8 Ways to Avoid the 3.8% Medicare Surtax

Tax planning is important every year, but with some tax provisions expiring and new ones taking effect this year, 2013 is an especially important year to examine your financial situation and plan accordingly. One of the new taxes that went into effect this year is the 3.8% medicare surtax.

Just what is the medicare surtax and what does it apply to?

The tax is a flat 3.8% and applies to the lesser of:
1. Net investment income, or
2. Modified adjusted gross income over a certain amount ($250,000 for married individuals filing jointly, $125,000 for those married but filing separately, and $200,000 for everyone else)

What exactly is net investment income and modified adjusted gross income?

This may be a bit much, but I promise my version is a lot simpler than the IRS’.

Net investment income is net income from… well, investments.  Specifically:

1. interest, dividends, royalties, annuities, and rent unless those items are ordinarily generated by a business that the medicare surtax doesn’t apply
2. a business that the medicare surtax does apply to (i.e., businesses that are either passive activities of a taxpayer or businesses that trade in financial instruments or commodities)
3. the disposition of property other than property held in a trade or business that the medicare surtax doesn’t apply

Got all of that?  Good.

Modified adjusted gross income (MAGI) is essentially your gross income minus certain deductions, such as alimony, student loan interest, moving expenses, HSA & IRA contributions, etc.  It’s important to note that for purposes of calculating your MAGI, if you took a deduction for income earned outside of the US, then that deduction would need to be added back.

MAGI includes both investment income (net investment income) and earned income (think wages, etc.).

Let’s say you sold land (investment income) for a profit of $82,000, earned interest of $10,000, and wages of $20,000.  Your net investment income would be $92,000 and your MAGI would be $112,000.  Also, it may be time to consider selling more land and quitting your day job (but, if your wife—or husband—asks, you didn’t get that idea from me).

OK.  Now tell me how I can avoid paying the surtax

Since the tax is charged on the lower of net investment income or MAGI over the threshold, any good strategy would involve either reducing investment income or lowering your MAGI—or income in general.

1. Lowering net investment income:

The most basic strategy would be to defer any additional income to the following years if at all possible.  Usually, an increase in investment income also increases your MAGI, while an increase in your MAGI may not increase your investment income.  Which means any increase in net investment income, if already subject to the surtax, also increases the surtax.  However, an increase in MAGI that doesn’t include investment income may not expose more income to the surtax.

Here’s an example to drive that last point home.

Let’s say Dan, a single guy, sold land for a profit of $10,000. Let’s also assume Dan makes a nice salary of $220,000. This year he wants to earn more money and can either work on a side project that could earn him an additional $30,000 in wages or he could try to sell another plot of land for a profit of $30,000. His MAGI is currently $230,000 ($220,000 in wages + $10,000 from the land sale). His net investment income is $10,000. Since the tax is charged on the lesser of net investment income or MAGI over the threshold—in this case $200,000 since he is single—he would be subject to a medicare surtax of $380 (3.8% on the lesser of $10,000 or $30,000).

Let’s assume he would really enjoy working on the side project and decides to do that instead of selling the additional plot of land. The additional $30,000 in wages would bring his MAGI to $260,000, while net investment income is still $10,000. This doesn’t affect the surtax since MAGI over the threshold is now $60,000, but his net investment income is still $10,000.  So, the surtax would still be charged on his $10,000 net investment income.

Now, what about if he sold the land instead of taking on the side project?  This would bring his MAGI to the same $260,000, however net investment income would now be $40,000. This means that the 3.8% tax would now be charged on $40,000 (lesser of $40,000 or $60,000). Increasing his surtax to $1,520.

In the above example, Dan may also want to pay attention to the capital gain rates and how that affects his taxes, but that’s another story for a different post.

2. Defer the sale of investment income to 2014:

If you don’t anticipate high MAGI or investment income for 2014, it may be wise to consider pushing the sale of land and other investment property such as homes or stocks to 2014 if at all feasible.  Doing this could either lower the surtax or avoid it altogether.

3. Use the installment method to spread out gain:

If you can’t completely defer a sale to next year, then instead of taking full payment upfront, consider structuring it as an installment sale.  Doing this will spread out the taxable gain on the sale, making part of the gain taxable in 2014, a year where you may not have as much net investment income or MAGI.

Let’s assume that Jane, a single individual, has MAGI of $150,000, which includes $50,000 of investment income. She has land that she could sell for a profit of $100,000. If she sold the land and collected all of the cash upfront, then that would increase her MAGI to $250,000, which would include $150,000 of net investment income. Making $50,000 subject to the surtax (lesser of $150,000 or $50,000).  However, since Jane isn’t a dealer, she could sell the land in an installment sale, collecting only 10% of the sale price upfront.  This means that she would claim only $10,000—10% of the profit—in 2013.  Doing this would give her net investment income of $60,000 and MAGI of $160,000, which means she wouldn’t be subject to the surtax at all.

4. Speed up recognition of losses:

If your net investment income is high and your total MAGI has passed the threshold for your filing status, it may be best to sell shares of stock at a loss (if you were planning on taking a loss on them anyway).  This has the added benefit of also reducing your capital gains tax as well.

5. Increase participation in passive income:

If you have a business that you don’t materially participate in, any gain from this business is likely to be considered net investment income. And it may be best to increase participation in the business to ensure that any income you earn from it isn’t considered net investment income.  While this will still be included in calculating your MAGI, if it’s relatively low, then it would be best to not expose another dollar of investment income to the tax.  This works just like #1 above where you wouldn’t want to increase investment income, but would prefer to increase your MAGI instead.

6. Consider the effects of a traditional or Roth IRA:

For purposes of the medicare surtax, the Roth IRA is more attractive for higher earners. This is because qualified distributions from Roth IRAs are tax-free and, therefore, won’t be included in the calculation of your MAGI.  Nor is it included in the calculation of net investment income. Distributions from traditional IRAs on the other hand, while still not considered net investment income, are mostly taxable, and is, therefore, included when calculating your MAGI and could potentially put you over the threshold for your filing status subjecting some of your income to the surtax.

7. Properly time conversions to a Roth IRA:

Conversions from a traditional IRA to a Roth IRA should be timed properly to keep MAGI low.  This year, the move could increase MAGI and potentially expose some of your income to the surtax. If possible, accelerate conversions this year if your income is relatively low, but will be high next year.  If your income is relatively high this year, but will be low next year, then do the reverse.

8. Consider the effects of required minimum distributions from retirement plans for those 70.5 and over

If you reached or will reach 70.5 in 2013 and are required to take minimum distributions from your IRA this year, you may want to consider making use of the 3-month delay and take your first distribution on April 1, 2014 if the minimum distributions will increase your MAGI to the point where it puts you over the threshold.  Deferring the required distribution to next year, a year when you may have lower MAGI, would make more sense.

Another option is to reduce this year’s taxable required minimum distributions and thereby reducing MAGI by making a qualified charitable distribution.

This list isn’t exhaustive, and, as is usually the case, changing one thing could affect not only the surtax, but could also affect other taxes such as self employment and the capital gains tax as well.  The point here is that it’s October, so there’s still plenty of time to take a look at your finances and make whatever changes you can to reduce your tax liability.

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