Don’t Be Blindsided By The New Medicare Surtax

Are you in the top tax bracket in 2012? Currently, the highest earners are required to pay tax at a rate of 35% on ordinary income such as salary and short-term capital gains. Once you reach the top bracket, every additional dollar of ordinary income you earn this year will be taxed at the 35% rate. Add in state and local taxes and you could end up losing a substantial chunk of what you’ve earned.

But this situation will get considerably worse if Congress doesn’t act before the end of the year. In addition to higher federal income tax rates that are scheduled to take effect in 2013, there will be a brand-new tax on investment income: the so-called Medicare surtax. This new provision was included in the massive health care law enacted in 2010.

The new Medicare tax is unlike virtually any other tax provision on the books. There’s already a Medicare payroll tax, but it applies only to earned income, such as wages, whereas the new levy hits money from your investments. However, with some advance planning, you may be able to reduce the tax impact next year, or even avoid the new tax altogether.

Under the new rules, the 3.8% surtax will apply to the lesser of:

• Your net investment income for the year; or
• The amount by which your modified adjusted gross income (MAGI) exceeds $250,000 ($200,000 for single filers).

For this purpose, “net investment income” includes interest, dividends, royalties, rents, gains from dispositions of property, and income from passive activities. But tax-free interest payments from municipal bonds and distributions from 401(k)s, IRAs, and other retirement plans are excluded. In effect, the new rules mean that if your MAGI exceeds the income threshold, your investment income up to the amount of excess MAGI will be subject to the surtax.

Suppose you are a single filer, your MAGI in 2013 is $350,000, and you have $100,000 in net investment income. Because your investment income is less than the amount by which your MAGI exceeds the $200,000 threshold, you owe the 3.8% Medicare tax on the $100,000 of net investment income, which adds $3,800 (3.8% of $100,000) to your tax bill.

If you think you’re in danger of triggering the 3.8% Medicare tax next year, start planning now to minimize the tax damage. These ideas might help.

• Sell some of your highly appreciated assets before the end of the year. As an added incentive to take profits now rather than later, this year’s maximum 15% tax rate on long-term capital gain will increase to 20% in 2013, barring any last-minute extension of the current rates. Assuming it makes sense from an investment standpoint, pull the trigger in 2012.  
• Increase your portfolio exposure to municipal bonds. Interest from tax-exempt obligations doesn’t count as investment income for the purposes of the new surtax. Be aware that muni offerings may become scarce at the end of the year, so start hunting now.
• Bulk up your 401(k). Like interest from munis, distributions from 401(k)s and other retirement plans aren’t included in calculating your net investment income. So the more you can sock away in your 401(k) account, within the generous tax law limits, the more you can shelter from the Medicare tax. Contributing more now also reduces your taxable income for 2012 and helps you accumulate funds for retirement.
• Convert a traditional IRA to a Roth IRA. Future qualified distributions from a Roth will be 100% tax-free. So it may be worthwhile to absorb the tax hit on a conversion this year (especially because tax rates are scheduled to increase next year).
• If you’re contemplating the sale of a business in which you hold a passive ownership interest, do it before 2013. The amount of your net investment income includes passive activity interest. 
• If you plan on selling your home soon, try to complete the sale before 2013. Generally, joint filers can exclude tax on the first $500,000 of gain from the sale of a principal residence ($250,000 for single filers), if certain requirements are met. But the 3.8% Medicare tax will apply to any portion of the gain that doesn’t qualify under this home sale exclusion.

As things stand now, the top tax rate on ordinary income will increase to 39.6% in 2013. When you tack on the 3.8% Medicare tax, your effective tax rate on investment income could be as high as 43.4%. Don’t stand by idly until the Medicare tax suddenly kicks in. Meet with your professional advisors to address your situation.