August 2011

Plan Now for the 3.8 Percent Medicare Surtax

The following article was contributed by Craig Conley, CPA, Clifton Gunderson LLP. For more information, contact Craig at craig.conley@cliftoncpa.com.

It’s been more than a year since the Patient

Protection and Affordable Care Act was passed.

What seemed at the time to be very distant

concerns are becoming more important every day. One such concern is the 3.8 percent Medicare surtax that will take effect

Jan. 1, 2013.

Intended to raise revenue to pay for health care reform, the surtax will apply to certain

types of unearned income of individuals, trusts and estates. Specific modified adjusted

gross income thresholds will apply.

A Tax on Net Investment Income

The new Medicare surtax will not apply to everyone. It will only be levied on net investment income, which includes:

• Interest, dividends, royalties, annuities, rents • Income derived from passive activities • Trading of financial instruments and commodities • Net capital gains derived from the disposition of property (other than property

held in an active trade or business

Net investment income does not include:

• Active trade or business income • Gain on the sale of an active interest in a partnership or S corporation • Distributions from IRAs or qualified retirement plans • Income from tax-exempt municipal bonds • Tax-deferred nonqualified annuities • Income taken into account for self-employment tax purposes • Capital gain excluded under the Internal Revenue Code.

Who is Affected?

For individuals, the 3.8 percent surtax would be imposed on the lesser of net investment

income for the tax year, or the amount by which the modified adjusted gross income

(MAGI) exceeds a threshold amount in that year. The modified adjusted gross income

threshold amounts are $200,000 for singles, $250,000 for married persons filing jointly and

$125,000 for married persons filing separately.

The new tax would also be imposed on trusts and estates on the lesser of the undistributed

net investment income for the tax year, or the excess (if any) of the taxpayer’s adjusted

gross income over the dollar amount at which the highest tax bracket begins.

Surtax Implications

• For a single taxpayer with $215,000 net investment income, the 3.8 percent

tax would apply to $15,000 of income – the lesser of net investment income

($215,000) and the excess over the MAGI threshold of $200,000. • A married couple with combined income of $275,000 and no net investment

income would not be subject to the surtax. • A married couple with combined salaries of $200,000 and net investment

income of $150,000 would pay the surtax on $100,000 of income – the lesser

of $150,000 of net investment income or the excess over the MAGI threshold of

$250,000.

Strategies to Reduce the Tax

Even though some are challenging the constitutionality of the Patient Protection Act, it is

best to assume that the Medicare surtax will take effect in 2013 and be around for awhile.

Taxpayers’ goal should be to manage income threshold limits and the level of net

investment income earned in a year. Here are some considerations to discuss with your tax and investment advisors:

• Income from municipal bonds is not considered net investment income.

Consider rebalancing your investment portfolio to increase exposure to

municipal bonds. • Consider selling your home before Jan. 1, 2013. Sale of a residence could

trigger the surtax if the taxpayer’s MAGI exceeds the prescribed thresholds and

the sale of the home results in a capital gain greater than the IRS exclusion of

$250,000 for singles and $500,000 for married couples. • Consider selling your business before Jan. 1, 2013. • Maximize contributions to retirement plans and IRAs. • Convert traditional IRAs to Roth IRAs (if you can afford to pay the taxes that

will be due).

Remember that planning for the Medicare surtax or any tax is just one part of a complete

wealth management plan. Consider your objectives and choose the actions that will help you achieve your goals.