Are you exposed?
You are only exposed to the 3.8% Medicare tax if your modified adjusted gross income (MAGI) exceeds the applicable threshold of: $200,000 if you are unmarried, $250,000 if you are a married joint-filer or qualifying widow or widower, or $125,000 if you use married filing separate status.
The amount subject to the 3.8% tax is the lesser of: (1) your net investment income or (2) the amount by which MAGI exceeds the applicable threshold. For this purpose, MAGI is defined as regular AGI from the bottom of page 1 of your Form 1040 plus certain excluded foreign-source income net of certain deductions and exclusions (most folks are unaffected by this add-back).
Strategies to minimize the tax must aim at the proper target
Because the 3.8% tax hits the lesser of your net investment income or the amount by which your MAGI exceeds the applicable threshold, strategies to avoid the tax must be aimed at the proper target. As I explained last week, the definition of investment incomecaptures a bunch of different types of income and gains, some of which may surprise you.
If your net investment income amount is lower than your excess MAGI amount, your exposure to the tax mainly depends on your net investment income. So you should focus first on strategies that will reduce net investment income. Some specific strategies are outlined below. Of course, some strategies that reduce net investment income will also reduce MAGI. If so, that cannot possibly hurt.
* If your excess MAGI amount is lower than your net investment income amount, your exposure to the tax mainly depends on your MAGI level. So you should focus first on strategies that will reduce MAGI. Once again, some strategies that reduce MAGI will also reduce net investment income. If so, that cannot possibly hurt.
Strategies to reduce net investment income
* Sell loser securities held in taxable brokerage firm accounts to offset earlier gains from such accounts. (This move will also reduce your MAGI.)
* Instead of cash, gift appreciated securities to IRS-approved charities. That way, the gains won’t be included on your return but you’ll still get your rightful charitable deduction. (This move will also reduce your MAGI.)
* If possible, become more active in business activities in which you’ve invested such as those conducted through partnerships and S corporations. The idea is to “convert” them from passive to non-passive because income and gains from non-passive business activities don’t count as investment income. Therefore, they are exempt from the 3.8% tax. The surest way to make an activity non-passive is to spend over 500 hours a year in it. In some cases, however, it can take only 100 hours or even less. Ask your tax pro for details.
* If possible, defer gains subject to the 3.8% tax by spreading them out with an installment sale (where you receive the sales proceeds over several years) or tax-free Section 1031 like-kind exchanges (where you swap an asset for a similar one). Investment real estate is the best candidate for these strategies. (These moves will also reduce your MAGI.)
Strategies to reduce MAGI
* Sell loser securities held in taxable brokerage firm accounts to offset earlier gains in such accounts. (This move will also reduce your net investment income.)
* Instead of cash, gift appreciated securities to IRS-approved charities. That way, gains won’t be included on your return. (This move will also reduce your net investment income.)
* Maximize deductible contributions to tax-favored retirement accounts such as 401(k) accounts, self-employed SEP accounts, and self-employed defined benefit pension plans.
* If you are a cash-basis self-employed individual, defer business income into 2014 and accelerate business deductions into 2013. I’ll have more on this subject as yearend approaches.
Longer-term strategies to avoid or minimize the new tax
The following ideas may not do much to reduce or eliminate this year’s exposure to the new 3.8% Medicare tax, but they could help a lot over the long run.
* Convert traditional retirement account balances to Roth accounts, but watch out for the impact on your MAGI in the conversion year. The deemed taxable distributions that result from Roth conversions are not included in your net investment income figure, but they increase MAGI ¬¬-- which may expose more of your investment income to the 3.8% tax in the conversion year. Over the long haul, however, income and gains that build up in a Roth IRA will be exempt from the 3.8% tax, because qualified Roth withdrawals are tax-free. Therefore they won’t increase your exposure to the 3.8% tax by increasing your MAGI, unlike withdrawals from most other types of tax-favored retirement accounts.
* Invest more taxable brokerage firm money in tax-exempt bonds. This would reduce both net investment income and MAGI. Use tax-favored retirement accounts to invest in securities that are expected to generate otherwise-taxable gains, dividends, and interest.
* Invest in life insurance products and tax-deferred annuity products. Life insurance death benefits are generally exempt from federal income tax and are thus exempt from the 3.8% tax. Earnings from life insurance contracts are not taxed until they are withdrawn. Similarly, earnings from tax-deferred annuities are not taxed until they are withdrawn.
* Invest in rental real estate and oil and gas properties. Rental real estate income is offset by depreciation deductions, and oil and gas income is offset by deductions for intangible drilling costs (IDC) and depletion. These deductions can reduce both net investment income and MAGI.
* Invest taxable brokerage firm account money in growth stocks. Gains are not taxed until the stocks are sold. At that time, the negative tax impact of gains can often be offset by selling loser securities held in taxable accounts. In contrast, stock dividends are taxed currently, and it may not be so easy to take steps to offset them.
The bottom line
Some of the strategies explained here are doubly effective because they can reduce your regular federal income tax (FIT) bill as well as your bill for the new 3.8% Medicare tax. If you’re self-employed, some of the ideas can cut your federal tax bill three different ways: by reducing your FIT bill, your bill for the 3.8% tax, and your self-employment tax bill. Finally, they might reduce your state income tax bill too. Since some of these strategies take time to implement, talk to your tax adviser right now. Waiting until later in the year could prove to be too late.
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Bill Bischoff for Marketwatch writes: The new 3.8% Medicare tax on net investment income took effect on January 1. It only affects higher-income individuals, but that can include anyone who has a big one-time shot of investment income or gain this year (or any other year). For example, if you sold some company stock for a big profit, you could be a victim. What to do? Read this for the first installment of our two-part series on strategies you can employ between now and the end of the year to avoid paying—or minimize your exposure to—the new tax.
Basics on the New Investment Income Tax
The following types of income and gain (net of related deductions) are generally included in the definition of net investment income and therefore potentially exposed to the new 3.8% tax.
- Gains from selling investment assets—such as gains from stocks and securities held in taxable brokerage firm accounts, and real estate gains (including the taxable portion of a big gain from selling your principal residence).
- Capital gain distributions from mutual funds.
- Gross income from dividends.
- Gross income from interest (not including tax-free interest such as municipal bond interest).
- Gross income from royalties.
- Gross income from annuities.
- Gross income and gains from passive business activities (business activities in which you don’t spend a significant amount of time) and gross income from rents.
- Gains from selling passive partnership interests and S corporation stock (you don’t spend much time in the partnership or S corporation business activity).
- Gross income and gains from trading in financial instruments or commodities.
Are You Exposed?
You are only exposed to the new 3.8% Medicare tax if your modified adjusted gross income (MAGI) exceeds the applicable threshold of: $200,000 if you are unmarried, $250,000 if you are a married joint-filer or qualifying widow or widower, or $125,000 if you use married filing separate status.
The amount hit with the 3.8% tax is the lesser of: (1) your net investment income or (2) the amount by which your MAGI exceeds the applicable threshold from above.
For this purpose, MAGI is defined as your “regular” adjusted gross income (AGI) from the last line on page 1 of your Form 1040 plus certain excluded foreign-source income net of certain deductions and exclusions (most folks are not affected by this add-back).
Strategies to Minimize the Tax Must Aim at the Proper Target
As explained earlier, the new 3.8% Medicare tax hits the lesser of: (1) your net investment income or (2) the amount by which your MAGI exceeds the applicable threshold. Therefore, planning strategies must be aimed at the proper target to have the desired effect of avoiding or minimizing your exposure to the tax.
- If your net investment income amount is lower than your excess MAGI amount, your exposure to the tax mainly depends on your net investment income. So you should focus first on strategies that will reduce net investment income. In my next article, I’ll provide some specific strategies for doing just that. Of course, some strategies that reduce net investment income will also reduce MAGI. If so, that cannot possibly hurt.
- If your excess MAGI amount is lower than your net investment income amount, your exposure to the tax mainly depends on your MAGI. So you should focus first on strategies that will reduce MAGI. In my next article, I’ll supply some. Of course, some strategies that reduce MAGI will also reduce net investment income. If so, that cannot possibly hurt.
Example 1: Targeting Net Investment Income.
In 2013, you and your spouse will file jointly. Unless something changes between now and year-end, you expect to have $450,000 of MAGI which will include $150,000 of net investment income. You will owe the 3.8% Medicare tax on all $150,000 of your net investment income because that amount is the lesser of: (1) your excess MAGI of $200,000 ($450,000 - $250,000 threshold for joint filers) or (2) your net investment income of $150,000. Your bill for the 3.8% tax will be $5,700 (3.8% x $150,000).
Your exposure to the 3.8% tax mainly depends on your net investment income level because that number is lower than your excess MAGI. Therefore, you should focus first on strategies that will reduce net investment income. For instance, you could sell some loser securities from your taxable brokerage firm accounts to offset earlier gains from those accounts.
In contrast, strategies that would lower your MAGI would not reduce your exposure to the 3.8% tax unless those strategies reduce your MAGI by quite a bit. For instance, making an additional $15,000 deductible contribution to your tax-favored retirement account would not by itself reduce your exposure to the 3.8% tax.
Example 2: Targeting MAGI.
In 2013, you will file as an unmarried individual. Unless something changes between now and year-end, you expect to have $300,000 of MAGI which will include $125,000 of net investment income. You will owe the 3.8% Medicare tax on $100,000 because that is the lesser of: (1) your excess MAGI of $100,000 ($300,000 - $200,000 threshold for single filers) or (2) your net investment income of $125,000. Your bill for the 3.8% tax will be $3,800 (3.8% x $100,000).
Your exposure to the tax mainly depends on your MAGI level because your excess MAGI number is lower than your net investment income. Therefore, you should focus first on strategies that would reduce MAGI. For instance, making $15,000 of additional deductible contributions to your tax-favored retirement accounts would reduce your MAGI by $15,000 and therefore reduce the hit from the 3.8% tax. Selling loser securities from your taxable brokerage firm accounts to offset earlier gains from those accounts would also reduce your MAGI.
Stay Tuned for Specific Strategies
In my next article, I’ll cover some specific short-term and long-term strategies that you can use to reduce or maybe even completely eliminate your exposure to the new 3.8% tax. Stay tuned!
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