What can I do now to minimize the impact of the new investment tax?

My wife and I have an adjusted gross income of over the $250,000 and we’re wondering if there is anything that we can be doing now to minimize the impact of the 3.8% tax. If we’re near that $250,000 threshold would it be wise to funnel any money above it into a retirement plan? Or are there any asset classes where the tax doesn’t apply?

 

Boston Money Coach Answer:

The surtax that you are referencing is a new provision contained in the Health Care and Reconciliation Act of 2010 that amended the Patient Protection and Affordable Care Act of 2010. Now that the US Supreme Court has ruled that the health care law is constitutional, this new provision takes effect in 2013.

Officially, the surtax is known as the Unearned Income Medicare Contributions Tax [“UIMCT”].

The UIMCT broadens the Medicare tax base for higher-income taxpayers by imposing a 3.8% surtax on the lesser of: (1) “net investment income”; or (2) the excess of adjusted gross income [AGI], increased by any foreign earned income otherwise excluded from AGI, over the taxpayer’s threshold amount. Net investment income does not include income from a trade or business, distributions from IRAs or qualified plans or tax-exempt municipal bond interest.

Without knowing the composition of your total income, it is difficult to provide specific recommendations. But based on the definitions of this new law, it appears that anything that can be done to reduce your AGI will be helpful.

So, avoid foreign earned income that is not otherwise exempted. Consider municipal bond income. You may consider contributing more to your qualified plans at work (maximum $17,000 in employee contributions plus any applicable catch-up if you are over age 50). You may consider annuities and cash-value life insurance as other places to put cash since these do not generate taxable investment income. If you have the opportunity to defer bonus income into another tax year, consider that as well. If you can operate or start a side-business (schedule C-type income), you may be able to use the start-up costs to reduce your net profit and subsequently your AGI.

Remember, the act only applies the surtax to investment gains when the total adjusted gross income on a return exceeds $250,000 for couples and $200,000 for single taxpayers. If your adjusted gross income is less than those amounts, the surtax will not apply. If you’re above those thresholds, then it applies only to the lesser of the net investment income or AGI above the mark.

If you had zero investment income but had salary income above $250,000, then you would expect to pay zero additional tax.  (So capital losses from previous years or passive activity losses are valuable and can be used to reduce your investment income).

A married couple with combined salaries of $200,000 and net investment income of $150,000 would pay the surtax on $100,000 of income since it is the lesser of $150,000 of net investment income or the excess over the MAGI threshold of $250,000.

Check out the Wall Street Journal Article on this issue.