The New 3.8% Medicare Tax on Unearned Income: What You Need to Know

The kids are back to school, the weather is getting cooler, and, yes, football season is in full swing. With thoughts of Halloween, apple pie and the holidays, we begin to wind things down for 2012. Lest we get too relaxed thinking about such niceties, we should be reminded of what lurks on the other side of midnight on New Years Eve: January 1, 2013. Why would such a date serve as a sobering event? Well, for one, that is the day the Estate Tax exemption amount drops from $5,120,000 to $1,000,000. Oh, you already knew that? OK, how about the all important capital gains rate, which for most people will increase from 15% to 20%? You heard something about that as well? Fine, but did you know about the new 3.8% Medicare tax on unearned income and how you’ll be affected by it?

As a bit of background, the existing Medicare tax applies to wages and net earnings from self-employment at a rate of 2.9% and is not limited to a certain wage base as is the Social Security tax. Employers are required to pay half of this tax, while the self-employed pay the entire amount themselves. When the “Health Care and Education Reconciliation Act of 2010” was passed by Congress as an amendment to the “Patient Protection and Affordable Care Act,” which together are referred to as “Obamacare,” a new Medicare tax was created as a means to raise revenue to pay for Obama’s health care reform.

First off, the new Medicare tax increases the existing 2.9% Medicare tax rate on wages and earnings to 3.8% (on wages above $200,000 on a single return, $250,000 on a joint return, or $125,000 if married filing separately), of which the additional amount is borne only by the employee.

In addition to wages and earnings, the new Medicare tax also applies to investment income (or “unearned income”) to the extent a taxpayer’s modified adjusted gross income exceeds $200,000 on a single return, $250,000 on a joint return, or $125,000 if married filing separately. Modified adjusted gross income is an individual’s adjusted gross income increased by the amount excluded as certain foreign earned income. Generally, investment income is any income derived from investments and other sources not related to employment services such as interest, dividends, capital gains, annuities, royalties, and rents not derived in the ordinary course of a trade or business.

Do you own an interest in an S corporation? Many of our clients will be surprised to know that the distributions from their passive investments, such as S corporations, will be subject to the new Medicare tax as well. However, the tax will not apply to operating income earned by active shareholders in the S corporation or other business entity, unless the operating income constitutes self-employment income subject to the Medicare tax on earned income.

As the thresholds reveal, the new tax affects wealthier taxpayers and will primarily impact income-generating investments. Accordingly, there are several tax planning techniques individuals and private enterprises should consider for 2013 to eliminate or lessen the impact of the new Medicare tax. Some planning techniques include: (1) deferring capital gains or pairing capital gains with capital losses to offset capital gains being taxed at a higher rate; (2) rebalancing your portfolio to shift income-producing investments into tax-deferred plans such as IRAs and 401(k) accounts; (3) considering tax -exempt bonds instead of taxable bonds; (4) reclassifying passive activity to active activity by evaluating any new factual patterns for each activity that would not lend itself to the tax; and (5) if you have an investment interest expense carryover into 2012, electing not to tax qualified dividends and long-term capital gains at the higher rate to preserve the investment interest expense as a carryover to future years. With January 1, 2013 fast approaching, it is important to not only understand the significance of the new Medicare tax on unearned income, but also consider developing tax planning techniques now to offset its impact on you and your investments.

So, go ahead, stuff yourself at Thanksgiving, break out that ugly sweater you got last year and party like it’s 2012, because in 2013 you may just not be in the mood.