Preparing for the 3.8% Medicare Surtax on Net Investment Income

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[authors: Neal A. Hudders and Mel Wheaton]

Background

The Patient Protection and Affordable Care Act of 2010 (Affordable Care Act) institutes a new 3.8 percent Medicare surtax on net investment income effective January 1, 2013. In addition, absent congressional action to extend the Bush tax cuts, the following tax increases are scheduled to take effect January 1, 2013: 

  • The tax rate on long-term capital gains will increase from 15 percent to 20 percent;
  • Qualified dividends will once again be taxed at ordinary income rates (meaning an increase from the current 15 percent rate to a rate potentially as high as 39.6 percent); and
  • The top marginal tax rate on ordinary income and short-term capital gains for individuals will increase from 35 percent to 39.6 percent.

Such pending increased tax rates, coupled with the new 3.8 percent Medicare surtax, make 2012 an attractive year to dispose of investment assets. 

Overview of the 3.8 Percent Medicare Surtax on Net Investment Income

Effective in 2013, net investment income will be subject to a new 3.8 percent surtax enacted as a part of the Affordable Care Act. Net investment income generally encompasses capital gains, dividends, interest, royalties, rents and passive activity income (such as an investment in a limited partnership). The 3.8 percent surtax will be in addition to any applicable increased capital gain or ordinary income tax highlighted above (bringing the total federal tax on long-term capital gains to 23.8 percent and on dividends and other net investment income to as much as 43.4 percent).

Individuals

For individuals, the 3.8 percent surtax will be imposed on the lesser of the following two amounts: 

  • Net investment income, or 
  • The amount by which adjusted gross income exceeds $250,000 (for married filing jointly taxpayers), $200,000 (for single filing taxpayer) or $125,000 (for married filing separately taxpayers).

For example, if a single filing taxpayer has adjusted gross income of $225,000 and net investment income of $75,000, the 3.8 percent surtax will only be imposed on $25,000 of such taxpayer's net investment income.

Trusts and Estates

For trusts and estates, the 3.8 percent surtax will be imposed on the lesser of the following two amounts:

  • Undistributed net investment income, or
  • The amount by which adjusted gross income exceeds the dollar amount at which the highest tax bracket for estates and trusts begins (anticipated to be approximately $12,000 for 2013).

Tax Exempt Entities

The 3.8 percent surtax will not apply to tax-exempt entities such as charities, charitable remainder trusts, IRAs or Roth IRAs.

Steps to Consider

In order to reduce the impact of the new 3.8 percent surtax, taxpayers should consider taking one or more of the following steps with respect to particular investment assets which they own:

Investment Assets Generally

If you currently own investment assets that have an appreciated value, consider disposing of such assets prior to the end of 2012 in order to trigger the tax on such appreciated value in 2012 under the existing lower tax environment.

Investment Assets Held Within an S Corporation

If you hold investment assets that have appreciated within an S corporation, consider simply making a distribution of such assets out of the S corporation, as such distribution itself will trigger the tax on the appreciated value to date of such assets at the lower 2012 rates without having to actually dispose of such assets to a third party.

Additional Information

This update is intended only as a general summary of the new 3.8 percent Medicare surtax under the Affordable Care Act.  Please contact counsel for more detailed information regarding the surtax and its potential application to your particular circumstances.

Topics:  3.8% Medicare Tax, Affordable Care Act, Medicare

Published In: Business Organization Updates, Finance & Banking Updates, Nonprofits Updates, Tax Updates, Wills, Trusts, & Estate Planning Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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