New Tax on Unearned Income Starts in 2013

As part of the Patient Protection and Affordable Care Act (popularly known as the “health care reform law”), an additional 3.8% tax on unearned income will apply to certain individuals.

Who’s Impacted by the 3.8% Unearned Income Tax?

Starting in 2013, the new tax, technically known as the “unearned income Medicare contribution,” applies to the net investment income of higher income individuals, trusts, and estates. For individuals, the tax is equal to 3.8% of the lesser of (1) investment income for the year or (2) the amount by which modified adjusted gross income (MAGI) exceeds the applicable threshold amount for the taxpayer’s filing status. These thresholds are:

Filing Status                      Threshold Amt.*

Individual Taxpayers        $200,000

Married (Joint)                 $250,000

Married (Separate)          $125,000

* These amounts are not inflation-adjusted.

Example. Bill’s 2013 MAGI is $250,000, $50,000 more than the $200,000 threshold for his single filing status. His net investment income is $60,000. Bill will owe the 3.8% tax on $50,000, since that amount is less than his $60,000 net investment income.

Definition of Net Investment Income

For purposes of the new tax, “net investment income” includes gross income from interest, dividends, annuities, royalties, rents (other than rents derived from a trade or business), and net capital gain. It also includes income from “passive” trade or business activities, such as pass-through income from limited partnerships, S corporations, and limited liability companies in which a taxpayer does not materially participate. The 3.8% tax does not apply, however, to qualified retirement plan and individual retirement account distributions.

Tax Planning Strategies

Taxpayers will have to plan carefully to minimize their exposure to the new tax. Various income-timing strategies may be effective, especially if a taxpayer’s MAGI is close to the applicable threshold.

Other strategies that may be helpful include, to the extent possible, offsetting capital gains with losses in the same year or investing in municipal bonds, since tax-exempt interest won’t be included in net investment income or MAGI for purposes of this tax.

Consider, too, maximizing your pretax contributions to retirement plans or selling appreciated investments in 2012 (before the new tax takes effect) instead of 2013.

We Can Help

Taxes are only one factor to consider when weighing investment decisions. Make sure you weigh all factors applicable to you. Contact us for more information on how the new additional tax on unearned income may affect your personal situation.

*To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax related matter.