Statscope

The 3.8% Medicare Tax: What You Need To Know

Statscope

On January 1, 2013, the US Government introduced a new Net Investment Income Tax of 3.8%. This tax only affects certain households or individuals that meet certain thresholds of net investment income or modified adjusted gross income (MAGI). Here is what you need to know.

What is Net Investment Income?

Net investment income is made up of the following:

  • Realized gains from investment assets such as stocks and bonds held in a taxable brokerage account and real estate (including residence)
  • Capital gains distributions from mutual funds
  • Income from dividends, interest, royalties, annuities, and passive business activities (rental properties for example)
  • Gains from the sale of passive partnership interest and S corporation stock
  • Gains from trading financial instruments (derivatives) and commodities

 

Does The Tax Apply to Me?

You will be exposed to the 3.8% Medicare Tax if:

  • Your MAGI exceeds applicable thresholds of: $200,000 if single, $250,000 if married filing jointly or qualifying widow or widower, or $125,000 if married filing separate.

 

How Much Will I Have to Pay?

Your tax exposure will be the lesser of:

  • Total Net Investment Income
  • The amount by which your MAGI exceeds applicable thresholds.

 

Example

Jane Doe is unmarried, is expected to have $100,000 in net investment income for this year and a modified adjusted gross income (MAGI) of $350,000. Her total tax exposure would be the lesser of:

  • Net Investment Income of $100,000
  • MAGI above applicable thresholds: $350,000 - $200,000 = $150,000

Jane’s total estimated tax would be 3.8% x $100,000, or $3,800. This of course would be on top of other federal, state (if applicable), or city (if applicable) income taxes that she pays every year.

What Can I Do to Minimize Potential Impact?

In general, the best way to minimize the potential impact of the Medicare Tax is to minimize net investment income or modified adjusted gross income. Here are a few examples:

  • Utilize tax-managed mutual funds in taxable accounts
  • Tax Loss Harvest when applicable
  • Maximize contributions to tax advantaged accounts such as 401(k)s, 403(b)s, 457, and IRA accounts

It should be noted that maintaining proper risk exposure within your portfolio should take priority over minimizing potential tax exposure. For example, not rebalancing a portfolio back to its target asset allocation in order to avoid potential capital gains is not prudent nor recommended. The potential losses for being exposed to risk beyond an investor’s capacity could be much more substantial, especially during market conditions from 2000 or 2008.

Index Fund Advisors is not a provider of tax advice, so please check with your accountant to review your various sources of income and how they may impact your tax liabilities. You can also find more information from irs.gov; specifically Topic 559 and Form 8960.