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The Medicare Surtax

The Affordable Care Act legislation (Obamacare) includes two new tax provisions. One tax, which took effect in 2013, is called the “unearned income medicare contribution”. This is a 3.8% tax imposed on investment income for some individuals, trusts, and estates. Some people will be unpleasantly surprised this tax season to find out about the tax, which hasn’t received much publicity. The tax applies to the following high income individuals and married couples and to some trusts and estates. I will refer to these amounts as the “surtax threshold”.

  1. Individuals with modified adjusted gross income of $200,000 or more;
  2. Couples filing jointly with modified adjusted gross income of $250,000;
  3. Couples filing separately with modified adjusted gross income of $125,000 or more (per spouse);
  4. Certain types of Trusts with net income of $11,950 or more; and
  5. Estates with net income of $11,950 or more;

High Income Individuals and Married Couples. To find out if you, or you and your spouse, are subject to this tax, you need to do two calculations. First, you have to determine your “modified adjusted gross income” (MAGI). To determine your MAGI, first determine your gross income, by adding the following amounts:

  • Wages, salaries, and tips
  • Taxable interest, ordinary dividends, rental income, and royalties
  • The taxable portion of your Social Security benefits, your pension, any annuity payments, and distributions from your IRA, 401(k), 403(b) or tax-deferred retirement accounts or plan
  • Business income, farm income, capitals gains or losses
  • Unemployment compensation
  • Alimony payments received
  • Distributions from partnerships and Subchapter S corporations
  • Trust income
  • Taxable income tax refunds

After determining your gross income, deduct the following from your gross income:

  • IRA deductions
  • Self employment expenses
  • Student loan interest
  • Alimony Paid
  • Health Savings Account contributions
  • Moving Expenses
  • Early savings withdrawal penalties
  • Educator expenses
  • Business expenses for certain professions

The result is your modified adjusted gross income. The above lists are not exhaustive. Ask your accountant if you are not sure about which items of your income are taxable and what your deductions are. For individuals whose modified adjusted gross income (MAGI) exceeds the surtax thresholds listed above, the 3.8% surtax is imposed on the lesser of a) their MAGI minus their surtax threshold; or b) their “net investment income” (NII). This is confusing, so I’ll illustrate this with some examples.

Example 1: In 2013, Mark had a salary of $175,000, net investment income of $50,000, and no deductions. His modified adjusted gross income is $225,000. He is over the surtax threshold of $200,000 for individuals, so the 3.8% surtax will be imposed. His modified adjusted gross income ($225,000) minus the surtax threshold ($200,000) is $25,000. This is less than his net investment income ($50,000), so the surtax will be imposed on $25,000. The tax is 3.8% of $25,000, or $950. Mark must pay this tax in addition to his usual income taxes.

Example 2: In 2013, Becky had a salary of $225,000, net investment income of $15,000, and no deductions. Her modified adjusted gross income is $240,000, so the 3.8% will be applied. The difference between her MAGI ($240,000) and the surtax threshold ($200,000) is $40,000. This is more than her net investment income of $15,000, so the surtax will be imposed on $15,000. The tax is 3.8% of $15,000, or $570. Becky must pay this tax in addition to her usual income taxes.

What is your net investment income? It is your investment income minus allowable investment expenses. The list of the items that make up investment income is very long and the rules about deductible investment expenses are complicated, so I will give a simplified explanation of how to calculate net investment income. If you are not sure what your NII is, you should consult with your accountant. There are three basic categories of investment income.

  • Gross income from interest, dividends, annuities, royalties and rent (excluding tax-exempt interest from municipal bonds and municipal bond mutual funds interest
  • Gross income from passive activity or a trade or business trading in financial instruments or commodities
  • Taxable Capital gains

Trusts and Estates. If you have a Trust, don’t panic. This new surtax will most likely not apply to you. If you have a “grantor trust”, also referred to as a “revocable trust” or a “living trust”, don’t worry about the tax. Any income earned by your trust is simply declared on your personal income tax returns. You do not have to file a tax return for your trust and you do not have to pay additional taxes on the trust income, known as “fiduciary taxes”. The trust income is simply part of your personal income.

The surtax is imposed on certain types of trusts, such as irrevocable trusts, and estates, that have adjusted gross income of $11,950 or more in a calendar year. Adjusted gross income (AGI) is the trust’s or estate’s income minus allowable deductions. If the AGI exceeds $11,950, the tax is imposed on the lesser of a) the AGI minus the threshold of $11,950 or b) the undistributed net investment income. The undistributed net investment income is the investment income that is not distributed to the beneficiaries of the trust or the estate. If investment income is distributed to you, as the beneficiary of a trust or estate, you will receive a Form K-1, showing your share of the trust or estate income and deductions that you must declare on our personal income tax returns. The 3.8% surtax applies only to undistributed, or retained, trust or estate investment income. Following is an example of how the surtax is calculated:

Example 1: In 2013, an irrevocable trust has total income of $17,500 and allowable deductions of $3,500. The AGI is $14,000, which is above the surtax threshold of $11,950. In this example, all of the income is investment income and none of it has been distributed, so the net investment income is $14,000. The AGI ($14,000) minus the threshold ($11,950) is $2,050. This is less than the net investment income, so the 3.8% tax will be imposed on $2,050, for a total surtax of $77.90. This tax is imposed in addition to the tax on the adjusted gross income, which is $3,901.80. The total tax on the trust income is $3,979.70.

Example 2: The same facts as Example 1, except that all of the net investment income ($14,000) is distributed to the beneficiaries of the trust. Each of the four beneficiaries will receive a Form K-1, showing that they have to declare $3,500 of investment income on their personal income tax returns. The trust does not have to pay any fiduciary taxes. The income distribution deduction (the amount distributed to the beneficiaries) will reduce the trust’s taxable income to zero. This is the strategy used by most trusts to reduce, or eliminate liability for fiduciary taxes, which now have a top tax rate of 43.4%, with the new surtax.

I’d like to make one more point about estate and trust distributions. Only the income portion of the distributions to the beneficiaries is taxable income to the beneficiaries. With some exceptions, most distributions from estates and trusts contain only a small percentage of income.

Example 3: Mary has established a revocable trust to hold title to her home and a rental property. She has established the trust to avoid probate. During her lifetime, she declares the rental income and deductions on Schedule E of her personal income tax returns. There is no need to file tax returns for the trust. After her death, her children, who are the Successor Trustees and beneficiaries, keep the trust in effect for six months, while they decide what to do with the real estate. Mary’s home is worth $200,000 and the rental property (a duplex) is worth $400,000. Mary’s two sons decide to keep the rental property as an investment. Mary’s daughter needs money for college tuition for her children. Mary’s home is sold. The sales proceeds of $200,000 are distributed to Mary’s daughter. Title to the duplex is deeded from the trust to Mary’s sons. There is net rental income of $2,400 left in the trust account. It is distributed, in equal shares, to Mary’s children. Each child receives a Form K-1 at the beginning of the next year, showing net rental income of $800 that they must declare on their personal returns. That is the taxable portion of their trust distributions. They are pleasantly surprised. They had expected to pay taxes on the entire distribution they received. The trust pay no taxes. All of the net income has been distributed.

The 0.9% Medicare Tax. In addition to the 3.8% surtax on investment income, there is an additional 0.9% Medicare tax on wages and self-employment income for those individuals and couples making more than the surtax thresholds listed above. This new tax also started in 2013. This 0.9% tax is added to the current 1.45% medicare tax that is paid by all employees. Your employer does not pay any of the 0.9% surtax. The basic medicare tax is 2.9%. Your employer pays half of this tax (1.45%) and you pay the other half (1.45%). If your gross salary exceeds the surtax thresholds listed above, the amount of your salary that exceeds the surtax threshold listed above will be taxed at the rate of 2.35%. Unlike the social security tax, the medicare tax does not stop when your salary reaches a certain level. Your entire salary is taxed. An example:

Example: Jack, a single taxpayer with a salary of $300,000 in 2013, will pay medicare tax at a rate of 1.45% on the first $200,000 of his salary ($2,900) and 2.35% on the $100,000 of his salary that exceeds $200,000 ($2,350). His total medicare tax for the year is $5,250. Like all new tax schemes, there are some problems. If you are married, how does your employer know what you and your spouse make? Your employer doesn’t know. Unfortunately, the burden falls on you, the employee, to make sure that the correct amount is being deducted from your paycheck. If you weren’t aware of this new tax in 2013, the IRS may be understanding. They will certainly want you to pay the tax that you owe (probably with interest), but the penalties may be waived.

If you would like more information about the new Medicare surtax, please
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