Planning for the New 3.8% Medicare Tax on Unearned Income

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By Tammy Clarke, CPA

President Obama’s Patient Protection and Affordable Care Act proposes a new and unprecedented Medicare tax that will directly affect many physicians. The tax, which goes into effect on January 1, 2013, is made up of two parts: an additional .9% surtax on earned income in excess of  $250,000 for married couples ($200,000 for individuals) and an additional 3.8% surtax on net investment income.

The 3.8% surtax on unearned income is known as the “Unearned Income Medicare Contribution.” This is an unprecedented and significant change in the tax structure. The surtax is calculated by multiplying 3.8% by the lesser of modified adjusted gross (MAGI) income over a $200,000 threshold for unearned income ($250,000 for joint filers) or, unearned income. Net investment income is income from interest, dividends, royalties, rents, capital gains, annuities, and income from a trade or business in which you do not actively participate, minus expenses allocable to that income. Note that investment income earned by a pass-through entity will be treated as owned by the individual.

The best way to explain how the surtax is calculated is by an example:  Let’s assume that John is married and they have $250,000 of salaries and $225,000 of net investment income totaling $475,000 of income. They will pay a surtax of 3.8% on the entire $225,000 of investment income because it is in excess of the $250,000 threshold amount for married couples. Therefore, their surtax would be $8,550 ($225,000 x 3.8%).

So, what should you do if you will likely be subject to the surtax? Consider increasing contributions to Traditional IRAs, Roth IRAs, qualified retirement plans and municipal (tax-exempt) bonds, in lieu of investments that generate taxable investment income. As an added benefit, distributions from Roth IRAs are tax-free and will not add to your future Modified Adjusted Gross Income. In addition, physicians may look to other insurance products to avoid the new tax. The inside buildup of life insurance cash surrender value is not subject to the new Medicare tax, nor are life insurance proceeds that are excluded from income tax.

Most efforts to limit this tax may take place in the last quarter of 2012 but planning can start now. During 2012 physicians should analyze their investment portfolios and consider harvesting any year-end gains, thereby limiting the 3.8% tax on top of the income or capital gain tax assessed on the gains.

Tammy B. Clarke, CPA • Alpern Rosenthal; E-mail: Phone: 561.689.7888 x214 (direct)