Your MAGI or your net investment income might put you at risk.
On January 1, a new 3.8% tax on certain kinds of investment income is set to take effect. The Medicare surtax (officially termed the Unearned Income Medicare Contribution) is slated to affect single filers with adjusted gross incomes above $200,000 and most joint filers with adjusted gross incomes above $250,000.
What is the most important thing to know about the new 3.8% tax? This has been characterized as a flat tax on investment income for the wealthiest Americans, but it is a little more complex than that.
The 3.8% surtax will actually be levied on the lesser of two amounts: either a) your net investment income or b) your modified adjusted gross income (MAGI) in excess of either the $200,000 or $250,000 threshold. Should either a) or b) be zero, the tax won’t apply to you in 2013.
Adjusted gross income is easily defined: it includes wages, income from partnerships and small businesses, retirement income, and interest, dividends and capital gains. Defining net investment income under the new surtax is a bit hazier, because (as of November) the IRS has yet to issue formal guidance.
What kinds of net investment income could be taxed? Many tax professionals believe the 3.8% surtax will apply to short- and long-term capital gains, dividends, interest (but not interest from muni bonds), royalties, returns realized from partnerships and activities not requiring material participation, and forms of income linked to real estate: passive income from rental property, income from the sale of a principal residence above the $250,000/$500,000 exclusion, and net gains from selling a second home.
Would certain net investment income be exempt? Besides muni bond interest, the surtax is not supposed to apply to regular or Roth IRA distributions, distributions from qualified retirement plans like 401(k)s and 403(b)s, veterans’ benefits, life insurance payouts, Social Security income or annuitized income from a retirement plan. Gains from the sale of property owned in an active trade or business would also be exempt, along with Schedule C income and income from a business on which you pay self-employment tax.
With the surtax looming, there has been an upswing of interest in Roth IRA conversions and the acceleration of investment income into 2012. Installment sales have also become less attractive to business owners, and family businesses who are considering a sale may want to make sure sons and daughters with an ownership interest are also employees rather than sitting on the sidelines.
What about the 0.9% tax? This is actually a payroll tax, so it only applies to employment income (the self-employed are not exempt). Like the 3.8% tax, it will kick in above the $200,000/$250,000 levels. While employers aren’t required to withhold the tax until an employee amasses $200,000 in wages, this tax could prove nightmarish for high-earning married professionals who file jointly in 2013: the first $200,000 of their individual wages wouldn’t be subject to such withholding, but their combined earned incomes would be taxed once they exceed $250,000.
It isn’t too late to strategize. If your MAGI or your net investment income might put you at risk for the tax, talk to a qualified financial or tax professional about your options for 2012 and 2013.
Your personal financial consultant – Monty