Obamacare Surtax Is Likely to Survive

August 4, 2017 11:58 AM
By Brian Dobbis
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So be sure to revisit ways to mitigate the impact of that 3.8% levy on investment income.

THE ROAD TO RETIREMENT with BRIAN DOBBIS 

In case you missed it, while the Republican-led Senate repeatedly failed its attempts to repeal the Affordable Care Act (ACA), there came news—surprising to some—that the Senate wants to retain the 3.8% net investment income (NII) surtax.

Assuming the ACA remains intact, or even if it is eventually repealed in part or wholly, the NII surtax likely will remain. So now may be a good time to reassess your clients’ potential exposure to the 3.8% surtax of investment income, while implementing strategies to avoid it.

In addition to the NII, the ACA created a 0.9% Medicare surtax. Both surtaxes were enacted in 2010, and went into effect in January 2013, as a way to help pay for the ACA. The two surtaxes accounted for 1.85% of the $1.45 trillion in individual income taxes the Internal Revenue Service (IRS) collected in 2015, according to the Statistics of Income Bulletin. The IRS also reports that 3.6 million taxpayers owed the additional Medicare tax in 2015, while 3.8 million owed the 3.8% NII tax. (For a breakdown of who pays that tax, see Chart 1.) Interestingly, none of the proceeds of the 3.8% Medicare surtax will flow into the Medicare trust fund. Instead, the revenue goes directly into the U.S. Treasury.

 

Chart 1. High-Income Taxpayers Pay Most of the 3.8% Surtax
The surtax on investment income is expected to bring in $30 billion this year.

Source: Tax Policy Center.

 

This 3.8% NII surtax will apply only to those taxpayers whose modified adjusted gross income (MAGI) exceeds $200,000 (filing single) or $250,000 (for married couples filing jointly). These amounts have remained flat, since they are not subject to cost-of-living adjustments. However, taxpayers whose MAGI is below the aforementioned levels will not be subject to the surtax.

For estates and trusts, the 3.8% surtax applies to the lesser of any undistributed net investment income or the excess of AGI over the dollar amount at which the top tax rate for estates and trusts begins. In 2017, the threshold is $12,500, since it, unlike the individual threshold, is indexed for inflation. (See Table 1.)

The 3.8% Medicare surtax (reported on IRS Form 8960 is applied on the lesser of net investment income or the amount of MAGI over the threshold amount. Generally, investment income includes such items as interest, dividends, long- and short-term capital gains, royalty income, passive rental income, etc.

 

Table 1. MAGI Income Thresholds for 3.8% Net Investment Income Surtax

Source: Internal Revenue Service.
Note: The NII surtax is assessed at the amount at which the top trust tax bracket is effective.  For 2017, the amount is $12,500.

 

Yet under such a broad category, what’s not considered investment income? In general, this includes municipal-bond interest, Social Security benefits, distributions from IRAs, Roth IRAs, and workplace plans (e.g., 401(k)). However, increasing MAGI via IRA (traditional, SEP, SIMPLE, and non-qualified Roth) distributions, 401(k) and 403(b) withdrawals, and Roth conversions can “swell income” and “push” a taxpayer above the applicable threshold amount, causing the taxpayer to be subject to the 3.8% surtax.  Qualified distributions from Roth IRAs and tax-free municipal bonds are potentially more valuable to those high-income earners.

For those taxpayers concerned with being assessed the taxes, there are a number of ways to reduce or potentially avoid NII exposure, such as reducing adjusted gross income (AGI). Also consider increasing pretax deferrals to a company plan (401(k), 403(b), 457, or SIMPLE IRA). Another is to make a deductible contribution to a traditional IRA. For those who are self-employed, he or she can fund a SEP IRA. All contributions to the above will reduce an individual’s AGI.

Also, for those investors subject to required minimum distributions (RMDs) from IRAs should consider using a qualified charitable distribution (QCD). A QCD satisfies the annual IRA RMD and is not included as income for the year. In other words, an investor’s AGI remains flat by utilizing a QCD. (For more on QCDs, click here.)  

Unfortunately, reducing AGI doesn’t help in regards to the 0.9% additional Medicare tax. This tax (reported on IRS Form 8959) applies to wages and self-employment income above $200,000 (single)/ $250,000 (married filing jointly) thresholds, not AGI. Those taxpayers with both high income and significant investment income can be subject to both the 3.8% net investment income tax and the 0.9% Medicare tax.

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