Get ready for the new 3.8% tax on investment income

The Patient Protection and Affordable Care Act of 2010 established a new 3.8% Medicare tax on investment income for high-income taxpayers, which is scheduled to take effect in 2013. The tax will also apply to trusts and estates, and the income threshold that triggers the tax for them is low.

Now that the U.S. Supreme Court has upheld most provisions of the health care act, these taxes ? barring congressional action ? will soon become a reality. This means they could take a bite out of the legacy you may be trying to build for your loved ones.

 

How it works

For individuals, the 3.8% tax will apply to net investment income (gross investment income less deductible investment expenses) to the extent modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for joint filers).

Suppose, for example, that you are a joint filer and in 2013 your MAGI is $400,000, which includes $75,000 in net investment income. Your net investment income is subject to the 3.8% tax to the extent your MAGI exceeds the $250,000 threshold ($400,000 − $250,000 = $150,000), so the entire $75,000 is taxable. The tax is $75,000 ? 3.8% = $2,850.

For trusts and estates, the 3.8% tax is imposed on undistributed net investment income for the year to the extent that adjusted gross income (AGI) exceeds the dollar amount at which the highest tax bracket begins ($11,650 in 2012 but will likely go up slightly for 2013). Some trusts are exempt, including certain charitable trusts, grantor trusts (because income is passed through to the grantor) and ?simple trusts? (because they distribute all current income to beneficiaries).

Net investment income includes the sum of the following, less any applicable deductions:

  • Gross income from interest, dividends, annuities, rents and royalties,
  • Net capital gains, and
  • Trade or business income that is considered either passive activity income or is derived from trading in financial instruments or commodities.

It does not include active trade or business income. Also excluded are distributions from IRAs and qualified retirement plans and income from tax-exempt or tax-deferred investments.

 

Tax planning strategies

For individuals, you can minimize or eliminate the 3.8% tax by reducing MAGI or the amount of net investment income ? or both. Potential strategies include:

  • Converting to a Roth IRA by Dec. 31, 2012,
  • Gifting income-producing investments to loved ones who will not be subject to the new Medicare tax,
  • Investing in growth rather than income stocks,
  • Investing in tax-free municipal bonds,
  • Selling appreciated capital assets before the end of 2012, or
  • Using installment sales to spread gain over several years.

Putting more money into traditional qualified retirement plans can also be a good strategy because contributions reduce taxable income and distributions are not included in investment income (although they do increase MAGI).

For trusts, reducing AGI usually is not an option, because the 3.8% tax?s threshold is so low. But there are several strategies trusts can use to minimize the tax, including shifting funds into tax-exempt or tax-deferred investments.

Also, because the 3.8% tax applies only to undistributed net investment income, a trust can reduce its tax liability by distributing more income to beneficiaries. Keep in mind, though, that these distributions may increase the beneficiaries? exposure to the tax.

 

Act now

With 2013 right around the corner, now is the time to take action. If the new 3.8% tax will affect you, consult your estate planning advisor to discuss potential strategies for reducing the impact.