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Tax Planning for Two New 3.8% Medicare Taxes

A version of this article was published in The Daily Record on May 30, 2013.

Since the passage of federal health care reform in 2010, tax professionals have been focusing on the number 3.8% and its potential effect on two Medicare-related taxes. Until recently, it was not clear that these new taxes would ever go into effect because of constitutional challenges to health care reform and demands by Republicans to repeal Obamacare.

However, the recent U.S. Supreme Court decision in National Federation of Independent Business v. Sebelius removed any doubt about the constitutionality of federal health care reform, and President Obama's re-election removed the potential of repeal. Therefore, it is now important for high-income taxpayers to start planning to mitigate certain adverse tax consequences of the reform.

A. Medicare Payroll Tax

The first encounter with 3.8% comes with the current Medicare tax on earned income. Beginning in 2013, the Medicare payroll tax increases by 0.9% (from 2.9% to 3.8%) on wages and self-employment income above $250,000 for joint filers and $200,000 for singles.|

This is not a new tax but the addition of a progressive element to what had been a flat tax on such earned income. Unlike the Social Security payroll tax, which is capped at a certain amount of wages or self-employment income, the Medicare payroll tax is uncapped.

B. New Surtax

The second encounter with 3.8% is a new surtax (and not just an increase in rate) on so-called "unearned income," and is equal to 3.8% of the lesser of a taxpayer's (1) net investment income, or (2) adjusted gross income (AGI) exceeding either a $250,000 or $200,000 applicable threshold depending upon the taxpayer's filing status.

For most taxpayers, investment income includes interest, dividends from passive activities, royalties, rents and annuities. It also, however, includes gains on the disposition of investment assets, including a personal residence and stocks. It does not, however, include income and gains from a trade or business in which the taxpayer materially participates.

In effect, the new surtax on unearned income is a flat tax on investment income above the $250,000/$200,000 thresholds, and these thresholds are not adjusted for inflation.

Importantly, gain from the disposition of an investment asset is subject to the 3.8% tax only to the extent it is taken into account in computing taxable income. This would exclude, for example, gain on the sale of a principal residence up to the exclusion amount of $250,000 for single taxpayers and $500,000 for joint filers, gain excluded under the like-kind exchange rules, and gain excluded on the sale of "qualified small business stock."

The potential effect of the new surtax on investment income can be illustrated by the example of a husband and wife earning substantial income from their investment in securities.

If their AGI before considering those investments is $210,000, and they have $25,000 in interest income from CDs and bonds, $45,000 in dividend income, and capital gains of $70,000 from the sale of stock, then their total investment income is $140,000, which raises their AGI to $350,000. Their excess AGI over the $250,000 threshold is $100,000, and is less than their $140,000 of net investment income. That lower amount is therefore the base against which the new 3.8% surtax is applied. In this example, the new surtax results in additional taxes of $3,800.

C. Strategies

There are a number of effective strategies that can be used to reduce AGI and/or net investment income, and thereby decrease the base on which the tax is paid. These include investing in tax-exempt bonds and tax-deferred annuities; utilizing Roth IRA conversions and charitable remainder trusts; and maximizing above-the-line deductions (which reduces AGI). Physician groups should also explore alternatives, such as the use of S-corporations, that decrease payroll earnings, but increase active dividend earnings.

In all cases, taxpayers should take quick action to explore strategies that keep these adverse tax changes to a minimum.


December 20, 2012




Rosen, Barry F.


Health Care