Understanding How the New Medicare Tax Affects Individuals

The 2010 healthcare legislation created a new 3.8 percent Medicare tax on net investment income collected by individuals, estates, and trusts. The new tax, which the IRS calls the NIIT, is effective for tax years beginning on or after January 1, 2013. So it’s now officially time to start planning to avoid or minimize the tax for this year. To do that, you need to understand how it works. Helpfully, the IRS issued proposed regulations that provide much-needed details.

Exempt from the NIIT

Retirement account distributions are exempt from the NIIT. Net investment income does not include distributions from qualified retirement plans and arrangements such as pension plans, profit-sharing plans, 401(k) plans, stock bonus plans, tax-favored annuity plans, tax-favored government plans, traditional IRAs, and Roth IRAs.

Self-employment income is also exempt from the NIIT. Net investment income does not include any income or deduction items that are taken into account in determining the taxpayer’s net self-employment income for purposes of determining liability for self-employment tax.

Exception: The exception to the preceding general rule is for income and deduction items attributable to the business of trading in financial instruments or commodities. These items are taken into account in determining net investment income that is potentially subject to the NIIT whether or not these items are taken into account in determining net self-employment income.

Here is the impact of the new tax on:

Individual Taxpayers – Taxpayers are exposed to the NIIT when their modified adjusted gross income (MAGI) exceeds certain thresholds. The threshold amounts are $200,000 for unmarried people; $250,000 for married joint-filing couples or qualifying widows and widowers; and $125,000 for those who use married filing separate status.

Notes: These thresholds won’t be adjusted for inflation, so more individuals will probably be hit with the NIIT in the future. Non-resident aliens are not subject to the NIIT.

The amount subject to the NIIT is the lesserof net investment income or 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 of U.S. citizens and residents living abroad net of certain deductions and exclusions.

Trusts and Estates – Trusts and estates are also exposed to the NIIT. Specifically, the NIIT applies to the lesser of the trust or estate’s undistributed net investment income or AGI in excess of the threshold for the top trust federal income tax bracket. For 2013, that threshold is only $11,950, so many trusts and estates will probably owe the tax this year.

Estimated Taxes – If the 3.8 percent NIIT is owed, it should be taken into account for quarterly estimated tax payment purposes to avoid the interest charge penalty on insufficient estimated payments and withholding.

Income and Gain Potentially Exposed

The following types of income and gain (net of related deductions) are generally included in the definition of net investment income and thus potentially exposed to the NIIT.

-Gain from selling assets considered held for investment — including investment real estate and the taxable portion of gain from selling a personal 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 gain from passive business activities (meaning business activities in which the taxpayer does not materially participate) and gross income from rents.

-Gross income from non-passive business activities (other than the business of trading in financial instruments and commodities) is excluded from the definition of net investment income, and so is gain from selling property held in such activities.

-Gain from selling partnership and S corporation interests held for investment.

-Gross income and gain from the business of trading in financial instruments or commodities (whether the taxpayer materially participates or not).

Calculating Net Investment Income

Net investment income is calculated in two steps.

Step 1. Add up the gross income and gains from the categories listed above.

Step 2. Reduce the total from Step 1 by deductions properly allocable to the income and gains quantified in Step 1. The result is your net investment income. Examples of allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes allocable to income and gains listed in Step 1.

Gains from Selling Personal Residences

When you sell a principal residence, the gain is federal-income-tax-free to the extent of the allowable exclusion (up to $250,000 for an unmarried taxpayer and up to $500,000 for a married joint-filing couple). Such tax-free principal residence gains are exempt from the NIIT. However to the extent a principal residence gain exceeds the exclusion, the excess is considered investment income that is potentially subject to the NIIT. Gain from selling a vacation property is also potentially subject to the tax.

Examples Illustrating How the NIIT Can Affect Individual Taxpayers

Example 1: In 2013, you file as unmarried. You have $325,000 of MAGI, which includes $95,000 of net investment income. You owe the 3.8 percent NIIT on all of your net investment income (the lesser of your excess MAGI of $125,000 or your net investment income of $95,000). The NIIT amounts to $3,610 (3.8 percent times $95,000).

Example 2: You and your spouse file jointly in 2013. You have $425,000 of MAGI which includes $145,000 of net investment income. You owe the 3.8 percent NIIT on $145,000 (the lesser of your excess MAGI of $175,000 or your net investment income of $145,000). The NIIT amounts to $5,510 (3.8 percent times $145,000).

Example 3: In 2013, you file as an unmarried individual with $199,000 of MAGI. You are exempt from the 3.8 percent NIIT, because your MAGI is below the $200,000 threshold for single taxpayers.

Example 4: You and your spouse file jointly in 2013 with $249,000 of MAGI. You are exempt from the 3.8 percent NIIT, because your MAGI is below the $250,000 threshold for joint filers.

Examples to Show How the NIIT Can Sneak Up on Some Home Sellers

Example 5: You are an unmarried. In 2013, you sell your greatly appreciated principal residence, which you’ve owned for many years, for a $600,000 gain. Thanks to the principal residence gain exclusion break, your taxable gain for federal income tax purposes is “only” $350,000 ($600,000 gain minus $250,000 exclusion for single taxpayers). The $350,000 gain counts as investment income for purposes of the 3.8 percent NIIT.

To keep things simple, assume you have no other investment income and no capital losses. But you do have $135,000 of MAGI from other sources (such as salary, self-employment income and taxable Social Security benefits).

Due to the big home sale gain, your net investment income is $350,000 (all from the home sale), and your MAGI is $485,000 ($350,000 from the home sale plus $135,000 from other sources).

You owe the NIIT on $285,000 (the lesser of your net investment income of $350,000 or your excess MAGI of $285,000 ($485,000 minus $200,000 threshold for singles). The NIIT amounts to $10,830 (3.8 percent times $285,000).

Example 6: You and your spouse file jointly and in 2013, sell a greatly appreciated vacation home you’ve owned many years. You have a $650,000 gain. That profit is fully taxable, and is also treated as investment income for purposes of the 3.8 percent NIIT.

To keep things simple, let’s say you have no other investment income or capital losses. But you do have $150,000 of MAGI from other sources.
Due to the vacation home profit, your net investment income is $650,000 (from the vacation home sale), and your MAGI is $800,000 ($650,000 from the vacation home plus $150,000 from other sources). You owe the NIIT on $550,000 (the lesser of your net investment income of $650,000 or your excess MAGI of $550,000 ($800,000 minus $250,000 threshold for joint-filing couples). The NIIT amounts to $20,900 (3.8 percent times $550,000).

Tax Planning Can Help Minimize or Avoid the NIIT

As you can see, the NIIT can be significant. However, it’s not inevitable. You can minimize or avoid the tax by taking steps to lower your MAGI and/or lower your net investment income. For example, you can lower your MAGI by making larger deductible contributions to tax-favored retirement plans and accounts for the 2013 tax year. You can lower both MAGI and net investment income by selling loser securities (worth less than you paid for them) held in taxable accounts before December 31. Consult with your tax adviser for other tax-saving moves to make between now and year end.