The 3.8 percent Medicare tax on investment income that will be imposed on higher-income individuals starting in 2013 has caught the immediate attention of many taxpayers.

Despite an effective date that is over 2-1/2 years away, people are already drawing up battle plans. Rather than "wait and let things happen," many individuals potentially within the reach of this new tax are turning to their tax advisors for advice. What should be done, long-term and short-term?

WHAT'S AT STAKE?

The genius of this tax, if one might indulge appreciation of "revenue maximization" for a moment, is that it is only 3.8 percent. While 3.8 is a respectable grade-point average and a decent alcohol content for most beers, it initially may not appear to be very formidable for tax-planning consideration. Planning for a 3.8 percent difference in tax may not appear worth the trouble, at first glance.

However, the "magic of compounding" can multiply the miniscule into a substantial amount. In addition, the effort placed on avoiding this 3.8 percent tax for the most part can double up in partnership with planning to avoid taxation of investment income in general. The 3.8 percent only makes the case for planning stronger.

BASIC COMPUTATION

The recently enacted health care package imposes a 3.8 percent Medicare contribution tax on qualified unearned income on individuals with certain "higher levels" of income. The 3.8 percent Medicare contribution tax is imposed on the lesser of an individual's net investment income for the tax year, or the excess of modified adjusted gross income in excess of $200,000 for an individual, $250,000 for married filers and surviving spouses, and $125,000 in the case of married individuals filing separately.

Although individuals without significant wage earned income might be subject to the 3.8 percent tax if investment income is substantial, most of the taxpayers who will bear the brunt of this additional tax will do so because of higher-than-average wage income. For two-earner householders, moreover, there is a distinct "marriage penalty," since the $250,000 floor for married filers is not even close to double the $200,000 floor for single filers.

Modified adjusted gross income for this purpose is AGI increased by excludable foreign-earned income or foreign housing costs under Code Section 911.

Net investment income for purposes of imposing the 3.8 percent tax is the excess of the sum of the following items, less any otherwise-allowable deductions:

Gross income from interest, dividends, annuities, royalties and rents, unless derived in the ordinary course of any trade or business;

Other gross income from any passive trade or business; and,

Net gain included in computing taxable income attributable to the disposition of property other than property held in any trade or business that is not passive.

These MAGI dollar caps are not adjusted for inflation. While inflation currently is relatively low, predictions are for a dramatic up-tick as the economy picks up. Each year, therefore, a greater number of individuals will be subject to the 3.8 percent surtax.

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