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The 3.8% Surtax Means You Need A 10-Year Tax Plan

Barring any unforeseen circumstances, the 3.8% Medicare surtax is here to stay. This controversial tax provision, included in the 2010 health-care reform legislation upheld in 2012 by the U.S. Supreme Court, will affect investors for the 2013 tax year and beyond. Unless Congress repeals the surtax, it’s the law of the land.

If you’re an upper-income investor, you need to consider the potential impact of the 3.8% surtax. What’s more, if you are nearing retirement, or if you’ve already retired, you should look closely at your tax future, taking this latest development into account. When you add the 3.8% surtax to the top federal income tax rate of 39.6%, you could end up paying an effective federal tax rate of 43.4% on a portion of your income.

First, let’s review how the 3.8% surtax works. Unlike the separate 0.9% surtax on “earned income” such as wages—another provision of the health-care law—the 3.8% surtax applies only to income from investments and other sources. Yet earned, noninvestment income still can push you above the threshold that triggers the tax.

The 3.8% Medicare surtax applies to the lesser of (1) net investment income (NII) or (2) the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount. That threshold is $200,000 for single filers and $250,000 for joint filers. For example, if you’re a joint filer with $50,000 of NII and MAGI of $225,000, you don’t have to pay the 3.8% surtax because the joint MAGI does not exceed the $250,000 threshold. However, if your MAGI is $350,000, you owe the surtax on the lesser amount of the $50,000 NII (compared with your $100,000 in excess MAGI). That will result in an extra tax of $1,900 (3.8% of $50,000).

How the IRS defines net investment income is crucial to these calculations. Under the provisions of the health-care law and subsequent regulations, NII includes (but is not limited to) income from the following:

Other kinds of income don’t count as net investment income. Items excluded from the calculation include:

One way to reduce your chance of having to pay the 3.8% surtax is to avoid the kinds of income that are treated as NII. However, even some of the things that don’t count as NII—such as distributions from an IRA or a qualified plan—will increase your MAGI and therefore still could cause surtax problems.

Another looming obstacle is that the threshold figures ($200,000 for single filers; $250,000 for joint filers) won’t be adjusted annually for inflation. That means more investors will be hit by the 3.8% surtax in the future. If inflation picks up, you might find yourself affected by the tax within just a few years.

One practical way to prepare for that likelihood is to project what your overall tax picture may look like for an extended period. Keep in mind that the top federal income tax rate of 39.6% will likely remain in effect, while the maximum tax rate on net long-term capital gains has increased from 15% to 20% for investors in the top ordinary income tax bracket. If you expect to benefit from large investment gains and sizable qualified plan and IRA distributions during retirement, your combined tax rate for federal and state income could approach or even exceed the 50% mark.

We can work with your tax advisor to help you develop a plan for the next 10 years, or even longer, that will take all of these tax factors into account. Such a plan might involve strategies for eliminating or reducing the 3.8% surtax—for example, by converting a traditional IRA to a Roth IRA, establishing a charitable remainder trust, or using life insurance, installment sales of property, or “leapfrog” annuities to defer income. You also might decide to increase your portfolio allocation to tax-exempt municipal bonds.