Friday, July 26, 2013

Q&A Series: The 3.8% Medicare Tax on Investment Income – START PLANNING NOW IF YOU HAVEN’T ALREADY!

This week's question comes from Christine, a high-earner with a substantial investment portfolio.

Q: I know we’re over halfway through the year, but I’m wondering what sort of strategy to employ regarding the Medicare tax on investment income that started at the beginning of 2013.

We’ve always felt that tax and investment planning go hand-in-hand, Christine, so we appreciate your question. With the increase to Medicare taxes under the health care reform package of 2010 that began on January 1, 2013, there is no stronger case for cohesive tax and investment strategies.


As a result of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, households with high incomes will be paying more into the Medicare system, via taxes on both earned and unearned income.

To start with, the Treasury Department defines high-income households as wages, unearned income or modified adjusted gross income (“MAGI”) of more than $200,000 for single individuals and above $250,000 for married filers. MAGI is adjusted gross income increased by excludable foreign-earned income and a few other items.

Beginning in 2013, workers with wages above the noted thresholds will have to pay an additional 0.9% in Medicare payroll taxes. This results in a high-income earner’s share of Medicare payroll taxes increasing from 1.45% to 2.35% of all wages. This includes self-employed individuals who exceed the thresholds.

Moreover, beginning in 2013, high-income households are subject to a new 3.8% Medicare tax on net investment income, also referred to as “unearned income.” The Treasury Department’s definition of unearned income includes capital gains, dividends, interest, annuities, royalties and rent received. It also includes income derived in the ordinary course of a trade or business if that activity is passive for the taxpayer.

“Net investment income” does not include tax-exempt interest from municipal bonds or municipal bond funds, withdrawals from retirement plans, or payouts from traditional defined-benefit pension plans or annuities that are part of retirement plans. Life insurance proceeds, veterans’ benefits, Social Security benefits, and income from S corporations or partnerships in which you actively participate are also exempt.

Note that it is perfectly possible for a taxpayer to be subject to the Medicare investment tax and not the Medicare payroll tax in circumstances where wages fall below the threshold but net investment income increases MAGI above the threshold.

Also take note that if you’re married and each spouse earns less than the stated individual threshold amount, but your total earned income combined exceeds the married filing jointly threshold, your employers won’t take your spouse’s income into consideration when figuring your Medicare tax withholding; they are only obligated to withhold 1.45% for Medicare tax. This means that you will owe the additional 0.9% on the amount by which you and your spouse exceed the combined income threshold. If you fall into that bracket, you should find out if you are potentially required to make estimated tax payments or if you should increase your withholding to cover this additional tax.

Keep in mind that taxpayers in the lower marginal bracket will qualify for the 15% rates in qualified dividends and long-term gains. However, taxpayers in the top marginal bracket of 39.6% (individual filers with incomes above $400,000 and couples above $450,000) pay a 20% long-term capital gains and qualified dividends rate plus the 3.8% Medicare surtax. There are other items these taxpayers need to consider, and therefore, it’s imperative to strategize with your tax and financial professionals as soon as possible to help navigate the potential tax consequences they are facing. We would be happy to help you in this capacity.

The Right Strategy

Now, on to the fun stuff – how to reduce or eliminate your tax burden if your income is above the stated thresholds. If you’re still working, reducing MAGI can be difficult, but one strategy is to maximize your qualified retirement plan contributions via your pre-tax wages. This is a great way to reduce your income if you’re close to the threshold while also building your tax-free retirement assets. Likewise, small business owners with 401(k) plans should consider contributing more to the plan, and if none exists, serious thought should be given to establishing a plan.

As discussed above, qualified distributions from 401(k), 403(b), IRAs, tax-sheltered annuities, and eligible 457 plans as investment income are not subject to the tax. They do, however increase MAGI in the year of distribution. So, if you expect to be close to the MAGI threshold when you begin taking minimum required distributions, you might consider the effect future taxable distributions will have on your exposure to the tax. A review of your particular situation may reveal that it would be better for you to contribute to a Roth (if you qualify to do so) since Roth investment income isn’t taxed immediately, nor is it taxed when it’s distributed (provided you have met the requirements).

As for coming up with a strategy concerning your net investment income, taking a look at municipal bonds or municipal bond funds might be worthwhile. But, municipal bonds are subject to their own specific risks as some municipalities continue to struggle with their fiscal situations. Indexing strategies or buy and hold strategies and tax loss harvesting may be especially useful as tax rates have crept higher. Also, focusing on entities paying qualified dividends can also alleviate some of the tax burden. For instance, the income produced by a corporate bond could be subject to a nearly 43.4% tax rate for those in the highest bracket. However the qualified dividend income generated from that same company’s common or preferred stock would be subject only to a 23.8% tax rate.

In very specific situations, it may also be useful to hold taxable interest investments or non-qualified dividend-paying investments in tax-deferred IRAs or tax-deferred annuities. Moreover, in rare cases and depending on your specific situation, permanent life insurance where the cash value isn’t considered net investment income when withdrawn may also make some sense. We would not suggest employing these particular strategies without a full review of your precise situation.

Thanks so much for your question, Christine. There are some complex planning challenges with this new tax, but with help from a qualified tax and financial advisor, you should be able to execute a well-designed plan that could reduce the potential impact of this new tax. Rollins Financial and Rollins & Associates would be happy to review your particular situation and devise a unified tax and investment strategy for you. Let us know how we can help!

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Danielle Van Lear, CPA
Eddie Wilcox, CFA

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