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?


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.


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.


Since net investment income subject to the additional 3.8 percent tax is gross income or net gain, reduced by deductions that are properly allocable to the income or gain, deduction offsets can be worth their weight, if not in gold, at least in 3.8 percent of any deduction.

Expenses such as depreciation and operating expenses clearly qualify, while indirect expenses such as tax prep fees also may qualify. Internal Revenue Service guidance is anticipated to clarify the extent to which certain deductions may be used as offsets. In the meantime, the allocation of deductions from 2010 or even 2011 into 2013 is a bit of a stretch, although traditional accelerated cost-recovery techniques certainly might be given a critical eye in any event, should predictions of a rise in the general tax rate also materialize.


The additional 3.8 percent tax for higher-income taxpayers, on top of likely increases in the general maximum capital gains tax rate to 20 percent (for a total 23.8 percent rate) and the possible reversion of the present dividend income tax rate from a current 15 percent rate to the ordinary income tax rate to its pre-2001 law's 39.6 percent level (for a total 43.4 percent rate), calls overall for a more intense focus on several variables. They include the need to increase tax basis to lower capital gain, recognize the differences in long-term and short-term capital gain (overlaid with the 3.8 percent tax indifferent to a short- or long-term holding period), and the value that carryover losses may play on tax liability.

For those homeowners with more appreciation than may be covered by the Sec. 121 exclusion of $250,000 ($500,000 for joint filers), the additional 3.8 percent paid on such a "once-in-a-lifetime" gain can be significant, especially if the sales proceeds are needed to fund a retirement. Similar considerations apply, but without the benefit of any exclusion, to the sale of a vacation home. A sale of such properties, before 2013, but hopefully after the market turns around a bit more generously, might be in order as a result.


Net investment income subject to the 3.8 percent tax will not include tax-exempt interest or tax-exempt income, including veterans' benefits. The yield on tax-exempt bonds and similar investments, therefore, will look more desirable to those individuals potentially subject to the 3.8 percent tax.

Tax-exempt income is also desirable in keeping AGI as low as possible, since only the excess of $200,000 ($250,000 for joint filers and $125,000 for marrieds filing separately) is subject to the tax. This allows taxable investment income to escape the 3.8 percent tax to the extent that tax-exempt income holds down AGI.


The addition of the 3.8 percent tax to a higher anticipated general dividends and capital gains rate makes the use of qualified retirement savings vehicles more attractive overall. As in the past, investment opportunities that would ordinarily throw off immediate taxable income can be made in a qualified contribution plan or IRA without any immediate tax. This benefit is now enhanced by the savings gained from avoiding the 3.8 percent tax, not only when the income is earned, but when it is paid out.

Maximizing contributions of pre-tax wages to a qualified plan can benefit the taxpayer in two ways: lowering the amount of AGI that may trigger the 3.8 percent tax on outside investment income, while at the same time building a nest egg that can continue earning tax-free income without concern over the 3.8 percent tax.

The new law makes it clear that distributions from qualified retirement plans such as 401(k) plans, 403(b) annuities and IRAs are not subject to the 3.8 percent tax as investment income. Nevertheless, they do increase AGI in the year of distribution, therefore once again increasing the likelihood of a 3.8 percent tax on other investment income. The better of two worlds in this case might be contributing to a Roth account, since investment income earned within the account is neither taxed immediately as earned or later when distributed.


Another exception explicitly carved out of the investment income subject to the 3.8 percent tax is reserved for income ordinarily derived from a trade or business, such as a sole proprietorship, that is not a passive activity under Code Sec. 469. Investment income from an active trade or business is also excluded. The tax also does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity's property would be derived from an active trade or business. S corporations may have an advantage over partnerships and limited liability companies, however, since they generate active income that is not subject to the Medicare contribution tax and, arguably, is not subject to the Self-Employment Contributions Act tax.

Nonresident aliens are also excepted from the 3.8 percent tax on the grounds that they do not benefit from Social Security. A foreign trust with U.S. real property, however, may be subject to the tax.


To compound the burden for the higher-income wage earner, an additional 0.9 percent Medicare tax will be imposed on the wages and self-employment income of certain high-income taxpayers on wage-based income received starting in 2013. The 0.9 percent Medicare tax will be imposed on individuals who receive wages in excess of $200,000 ($250,000 for joint filers). Like the 3.8 percent tax, it will be imposed on the joint earnings of married individuals, rather than under the traditional tax assessment of wage earners based on individual wage caps (for example, earnings in excess of $106,800 in 2010).


Although the 3.8 percent tax on investment income for higher-income taxpayers will not start to be imposed until 2013, preparing for this tax can be made more cost-effective when combined with the anticipated general rate increases for capital gains, dividends and ordinary income. Certain steps may be taken now, including starting to maximize account balances in qualified tax-deferred accounts, balancing a portfolio with additional tax-exempt securities, thinking twice before instinctively deferring income, timing more carefully the sale of big-ticket capital items, and managing with closer scrutiny the recognition of current gains and the carryover of losses.

Protecting overall return on investment often requires an incremental approach in which each dollar saved, including those on taxes, can change the yield curve significantly over time. Those dollars otherwise not spent on the new 3.8 percent tax should now go into that equation.

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