Before we jump into how the tax may be calculated, keep in mind after reviewing a few of the examples below, this law probably should have been called the “Full Employment Act for Lawyers, Accountants and Financial Advisers.” As most stunt TV shows warn, “Do NOT try this at home.” If you have a complicated tax situation, consider professional help — at least the first year.
Let’s start with some definitions. Net investment income includes interest, dividends, capital gains, rent, income derived from passive activity, etc. The “threshold amount” is the key factor in determining the “lesser of” formula for purposes of calculating the tax. This threshold amount is what defines “high-income earners,” which is more than $200,000 in modified adjusted gross income (MAGI) for single filers and $250,000 for married filing jointly. There are different threshold amounts for those married filing separately, and estate and trusts. Now, our favorite: modified adjusted gross income. For Medicare surtax on investment income, MAGI is calculated as your adjusted gross income plus your net foreign earned income exclusion.
The 3.8% Medicare surtax will generally be imposed on the lesser of your net investment income or the amount of your MAGI that exceeds the threshold amount.
This is best explained by a few examples: John and Denise are married and file a joint tax return reporting a combined earned income of $275,000 and $60,000 of investment income from dividends and capital gains. Their adjusted gross income is $335,000. They do not have any foreign income exclusions. First, calculate their net investment income: $60,000. Second, calculate their MAGI in excess of the threshold amount = $335,000 - $250,000 for joint filers = $85,000. Apply the 3.8% tax to the lower of net investment income or MAGI over the threshold = $60,000 in this case. Their Medicare surtax should be $60,000 x 3.8% = $2,280.
However, not all high-income earners will be subject to this tax. Take for example Doris, who earns a salary of $350,000 but has no net investment income. Since the tax is applied to the lesser of net investment income or MAGI that exceeds the threshold, the 3.8% surtax would not apply. Wages are exempt from this particular Medicare surtax.
Let’s take a look at a more complicated situation: David and Valerie have W2 income of $375,000, interest and dividends of $6,000, capital losses of $2,500, Schedule K-1 income of $78,000 from an S-corp in which they materially participate, and a Schedule E real estate loss of $8,500. The $78,000 is considered active income, therefore, not counted. Their net investment income is only $3,500 ($6,000 minus the loss of $2,500). The Schedule E real estate loss is a suspended passive activity loss, which can only offset a passive gain. With no foreign income, their Medicare surtax should only be $133 despite having MAGI of $456,500.
These are just a few examples of how this new tax may affect investors. Next week I’ll take a look at how to plan to minimize the surtax.