With the imposition of the new Medicare Surtax (“Surtax”) effective January 1, 2013, the U.S. income tax system has become more complex and costlier to “high income” taxpayers. This tax is an additional 3.8% surcharge levied on the unearned income of these individuals. To learn more about income subject to the Surtax and some simple ways to minimize your tax impact, read on.
By definition, “high income” taxpayers are those with modified adjusted gross income (“MAGI”) in excess of the following thresholds:
- $200,000 for single taxpayers
- $250,000 for married taxpayers filing joint returns
- $125,000 for married taxpayers filing separate returns
What’s Included? What’s Not?
Income subject to the Surtax, otherwise known as Net Investment Income (“NII”), includes: interest, dividends, net capital gains, rental income, royalties and income derived from passive activities. NII also includes business income from trading in financial instruments or commodities (i.e. hedge fund income).
The following income is excluded from NII: municipal bond interest; investment income and net gains from the sale of property used in activities in which the taxpayer materially participates; tax-free gains from the sale of a principal residence; and qualified retirement plan distributions. It should be noted that although qualified retirement plan distributions are excluded from NII, these distributions increase MAGI and, in turn, may trigger the Surtax.
Adding It Up: How Net Investment Income is Calculated
To calculate NII, gross investment income is reduced by allocable expenses. Certain investment expenses will be subject to the 2% AGI floor used in computing miscellaneous itemized deductions. Once NII has been calculated, the amount subject to the Surtax equals lesser of 1) NII OR 2) the excess of the taxpayer’s MAGI over the applicable threshold.
As previously stated, rental income from passive activities is subject to the Surtax; whereas, rental income earned in a taxpayer’s trade or business is not. Real estate investors need to pay close attention to how their rental activities are classified because the imposition of the Surtax hinges on this determination.
How to Minimize the Surtax’s Impact
Taxpayers can minimize the impact of the Surtax by decreasing their NII and/or MAGI. Simple strategies include:
- Investing in tax-exempt bonds whose earnings are excluded from NII.
- Timing income so that NII is limited and/or MAGI falls below the threshold amount.
- Rebalancing investment portfolios by acquiring growth products rather than income producing products. Although both types of investments generate NII, by investing in growth products, taxpayers can control the timing of the income to limit the Surtax’s impact.
Taxpayers can also implement more complex strategies to minimize the Surtax’s effect through the use of charitable remainder trusts, life insurance policies and family owned partnerships, LLCs and S corporations.
Trusts and estates whose income is taxed at the highest tax rate are also subject to the Surtax. The amount subject to tax is the lesser of the 1) undistributed net investment income OR 2) excess of the adjusted gross income over the highest tax bracket amount ($11,950 for 2013).
Contributed by Ann Marie G. Davis, CPA, JD, a supervisor in RKL’s Tax Services Group. Ann Marie has over 20 years experience in serving individual clients with their tax planning needs specializing in high net worth individuals and tax controversy issues.