The purpose of this article is to outline what those changes are and what investments might be suitable in order to mitigate the negative effect of this new tax, which is scheduled to begin with the 2013 tax year.
All things considered, the new Medicare tax has the effect of raising the marginal income tax rate for those taxpayers who fall into certain income levels.
First, there will be a 0.9% surtax on earned income for single taxpayers with a salary or self-employment income of $200,000 or more per year. If you are married and filing jointly, then the income threshold is $250,000 per year. Currently, both the employee and the employer are responsible for contributing 1.45% each to the Medicare tax for a total of 2.9%. You, as the employee, will be responsible for remitting the extra 0.9% — so your portion is 2.35% and the total contribution is 3.8% — if your income exceeds the threshold.
Second, a separate 3.8% surtax will be imposed on the lesser of your net investment income for the tax year, or the amount by which your modified adjusted gross income (MAGI) exceeds the “threshold amount” for the year.
Let’s look at these terms a bit more closely. Net investment income is defined as interest, dividends, annuities, capital gains, rents and royalties. (There are some exclusions; your financial advisor can provide guidance.) The threshold amounts for MAGI are, once again, $200,000 for single taxpayers and $250,000 for married taxpayers.
For example, if you are married and filing jointly and you earned a total of $200,000 and you have a total net investment income of $100,000, you would have a total MAGI of $300,000. The 3.8% surtax applies to $50,000 of income since it is the lesser of $100,000 of net investment income or the excess of your MAGI over the threshold of $250,000.
Strategies to mitigate the new tax
The key to minimizing this new surtax is to reduce your net investment income. Among the investment choices you may want to consider are tax-free municipal bonds, tax-deferred annuities and non-income-producing real estate, as well as certain trust strategies. (There are also Medicare surtax implications for trusts and estates, but that discussion is beyond the scope of this article.)
As always, you shouldn’t let the tax tail wag the investment dog. Your investment choices should, first and foremost, reflect your long-term financial objectives; tax implications are a consideration, not the driving force.
Be sure to consult your financial advisor for a complete discussion of the surtax. He or she can clarify how it might affect your particular financial situation.
Abigail Rosen is a financial adviser at Brinton Eaton, a fee-only, SEC-registered investment advisory firm based in Madison, N.J. She can be reached at firstname.lastname@example.org or (973) 984-3352.