Individual Taxpayers and The 3.8% Medicare Surtax
The 2010 Patient Protection and Affordable Care Act, which the Supreme Court largely declared constitutional last month, contains several new taxes. Among the most significant is the new 3.8% Medicare surtax on investment income which takes effect January 1, 2013.
The new Medicare tax, designed to raise revenue to offset the cost of health care reform, applies to individuals earning more than $200,000 and married couples earning more than $250,000. The Medicare tax is imposed on the lesser of:
- Net investment income for the tax year; or
- The amount by which the modified adjusted gross income (“MAGI”) exceeds $200,000 for individuals and $250,000 for married couples.
Net investment income includes the following items, reduced by deductions allocated to such income:
- Interest, dividends, royalties, annuities, and rents
- Income derived from passive activities
- Trading of financial instruments and commodities
- Net capital gains derived from the disposition of property not held in an active trade or business
Net investment income does not include:
- Active trade and/or business income
- Any of the above sources of income (e.g. interest, dividends, capital gains, etc.) if derived from an active trade and/or business
- Distributions from IRAs or other qualified retirement plans
- Any income taken into account for self-employment tax purposes
Single Individual. John has $215,000 of dividend, interest, and rental income with no other sources of income. The 3.8% Medicare surtax applies to $15,000 of income since it is the lesser of net investment income of $215,000 or the excess of the $200,000 MAGI threshold.
Married Filing Jointly without Net Investment Income. John and Jane file a joint return reporting $300,000 in salaries and do not have any net investment income. The 3.8% Medicare surtax does not apply.
Married Filing Jointly with Net Investment Income. John and Jane file a joint return reporting $225,000 in salaries and $75,000 of interest, dividend, and rental income for a total MAGI of $300,000. The 3.8% Medicare surtax applies to $50,000 of income because it is the lesser of the couple’s $75,000 of net investment income or the excess over the $250,000 MAGI threshold.
IRA Distributions. In 2013, Michael, a single taxpayer age 69, has investment income of $150,000 and is not subject to the Medicare surtax. In 2014 when he turns 70 ½, Michael takes a $125,000 required minimum distribution from his IRA in addition to $150,000 of investment income. In this case, the 3.8% Medicare surtax applies to $75,000 of income because it is the lesser of his $150,000 net investment income or the excess over the $200,000 MAGI threshold.
Even though various provisions of The 2010 Patient Protection and Affordable Care Act are likely to be challenged well into the future, it is best to consider the new Medicare surtax as being permanent and plan accordingly.