The new 3.8% Medicare surtax on net investment income (NII) appears to be here to stay. If this tax caught you by surprise when you filed your 2013 tax return, you should be better prepared this year.
→ Here’s how the tax works.
If your investment income exceeds certain thresholds, you may owe a 3.8% Medicare tax on the excess. The taxable amount would be the lesser of (a) your net investment income (NII), or (b) the excess of your “modified adjusted gross income” (MAGI) above $200,000 for singles, $250,000 for spouses filing jointly, or $125,000 for spouses filing separately. MAGI is adjusted gross income increased by certain deductions and exclusions.
Net investment income includes items from most taxable income sources, such as interest, dividends, capital gains, passive activity income, and the like. However, certain other items – including income from an active trade or business, tax-exempt interest and distributions from qualified plans and IRAs – are specifically exempt.
Note that items exempted from the definition of NII could still cause problems because of the way the surtax is calculated. For instance, if you’re over age 70½ and you take a required minimum distribution (RMD) from your IRA, the payout increases your MAGI. This could push you over the threshold for the 3.8% surtax or add to the amount you already owe.
→What can you do now to reduce your exposure to the surtax? Consider these five potential strategies.
- Time income to stay below the threshold. For example, you might delay the sale of securities until next year or sell real estate property on the installment sale basis to reduce current capital gains.
- Include municipal bonds (“munis”) in your investment portfolio. Income from munis doesn’t count as NII or increase your MAGI for this purpose.
- Avoid the passive activity rules. By meeting the tax law test for “material participation,” you might be able to turn a passive activity into a regular business activity. But be aware that special rules affect rental real estate activities.
- Convert traditional IRA funds into a Roth. Because qualified Roth distributions are generally tax-free, this may avoid future problems. Calculate the optimal amount to convert for your personal situation.
- Maximize deductible contributions to traditional IRAs, 401(k) plans, or similar sheltered investments. Earnings in these accounts are not included in NII, and the contributions will reduce your MAGI.
At the very least, you can’t simply ignore the surtax and hope it will go away. Develop a tax plan for 2014 that takes the relevant factors into account.