One of the many changes that stem from the Affordable Care Act that have gone into effect this year is the 3.8% Medicare tax on net investment income. This tax will only affect people who fall into higher-income tax brackets, but if you’ve ever received a one-time, huge investment income gain (whether it was this year or any previous year), you may be susceptible to it. In this two-part blog, we will discuss how the new 3.8% Medicare tax will affect those who are subject to it, and what you can do to lessen the blow.
Your Modified Adjusted Gross Income (MAGI) will determine whether or not the new Medicare tax will apply to you. If you’re not married and your MAGI exceeds $200,000; married and file with your spouse (or qualifying widow/widower) and your MAGI exceeds $250,000; or married and file separately and your MAGI exceeds $125,000, you are exposed to the 3.8% Medicare tax.
Your entire income won’t be subject to the 3.8% tax. Between your net investment income or the amount by which your MAGI is greater than the cutoff for your filing status, whichever amount is less is the amount that is subject to the tax. In this situation, the government defines MAGI as your regular adjusted gross income from the bottom of the first page of your Form 1040, plus some excluded foreign-source income net of particular deductions and exclusions. Most people aren’t affected by that part, though.
How to Save Where You Can
The first step to minimizing the tax for which you’re liable is knowing exactly what types of income and gains are susceptible to being taxed. The 3.8% tax will affect whichever is less between your net investment income and the amount by which your MAGI exceeds the designated mark. In order to figure out how to save, you need to identify which of your amounts will be taxed.
If your net investment income is less than your excess MAGI, you’ll need to focus on your net investment income, because that’s what’s going to be taxed. You should concern yourself with building a strategy to reduce your net investment income as much as possible, to reduce the amount subject to the tax. Some strategies to reduce your net investment income will simultaneously reduce your MAGI, but that won’t hurt you either way.
If your excess MAGI is less than your net investment income, you should direct your attention to your excess MAGI, because that’s the amount that’s subject to the tax. Strategize ways to reduce your MAGI to decrease the amount on which you’ll be taxed. Again, these strategies may also reduce your net investment income, but that can’t hurt you.
How to Reduce Net Investment Income and MAGI
- Loser securities are those that you’ve lost money on—sell them to offset gains you’ve received through more profitable investments.
- When giving to IRS-approved charities, give appreciated securities instead of cash, because you won’t have to include the gains on your tax returns. Doing it this way, you’ll be able to get the deduction to which you’re entitled by donating, and you avoid having those gains count against you on your returns.
- Spread out any gains that would be subject to the 3.8% tax with an installment sale, which enables you to receive the sales proceeds over several years. Another option is to spread them out with a tax-free Section 1031 like-kind exchange, where you can swap one asset for another similar one. By doing this, you’re deferring your gains, reducing the amount that is subject to the tax.
How to Reduce Net Investment Income
- If you’ve invested in business activities conducted through partnerships or S corporations, try to get more involved in them. If you can “convert” these activities from passive to non-passive, any income or gains derived from them don’t count as investment income. If those gains aren’t considered investment income, then they’re exempt from the 3.8% Medicare tax. Consult the tax professionals at DeFreitas and Minsky LLP to discuss the specifics of your individual case, but most often, an activity will be deemed non-passive if you spend over 500 hours doing it every year. Sometimes, you can dedicate even less than 100 hours annually to an activity for it to be considered non-passive. Clarifying your requirements with a professional is key to ensuring you dot all your i’s and cross all your t’s.
How to Reduce MAGI
- If you have any tax-favored retirement accounts, such as 401(k) accounts, self-employed SEP accounts, and self-employed defined benefit pension plans, contribute the maximum that you’re allowed, since your money is able to go in untaxed.
- If you own your own company that is cash-based, defer any business income that you can into 2014 and accelerate the business deductions that you’re able into 2013.