Get ready for the new 3.8% tax on investment income

The Patient Protection and Affordable Care Act of 2010 established a new 3.8% Medicare tax on investment income for high-income taxpayers, which went into effect Jan. 1, 2013. The tax will also apply to trusts and estates, and the income threshold that triggers the tax for them is low. These taxes can take a bite out of the legacy you may be trying to build for your loved ones.

How it works
For individuals, the 3.8% tax will apply to net investment income (gross investment income less deductible investment expenses) to the extent modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for joint filers).

Suppose, for example, that you're a joint filer and in 2013 your MAGI is $400,000, which includes $75,000 in net investment income. Your net investment income is subject to the 3.8% tax to the extent your MAGI exceeds the $250,000 threshold ($400,000 − $250,000 = $150,000), so the entire $75,000 is taxable. The tax is $75,000 × 3.8% = $2,850.

For trusts and estates, the 3.8% tax is imposed on undistributed net investment income for the year to the extent that adjusted gross income (AGI) exceeds the dollar amount at which the highest tax bracket begins ($11,950 in 2013). Some trusts are exempt, including certain charitable trusts, grantor trusts (because income is passed through to the grantor) and "simple trusts" (because they distribute all current income to beneficiaries).

Net investment income includes the sum of the following, less any applicable deductions:

  • Gross income from interest, dividends, annuities, rents and royalties
  • Net capital gains
  • Trade or business income that is considered either passive activity income or is derived from trading in financial instruments or commodities.

It doesn't include active trade or business income. Also excluded are distributions from IRAs and qualified retirement plans and income from tax-exempt or tax-deferred investments.

Tax planning strategies
For individuals, you can minimize or eliminate the 3.8% tax by reducing MAGI or the amount of net investment income — or both. Potential strategies include:

  • Gifting income-producing investments to loved ones who won't be subject to the new Medicare tax
  • Investing in growth rather than income stocks
  • Investing in tax-free municipal bonds
  • Using installment sales to spread gain over several years.

Putting more money into traditional qualified retirement plans can also be a good strategy because contributions reduce taxable income and distributions aren't included in investment income (although they do increase MAGI).

For trusts, reducing AGI usually isn't an option, because the 3.8% tax's threshold is so low. But there are several strategies trusts can use to minimize the tax, including shifting funds into tax-exempt or tax-deferred investments.

Also, because the 3.8% tax applies only to undistributed net investment income, a trust can reduce its tax liability by distributing more income to beneficiaries. Keep in mind, though, that these distributions may increase the beneficiaries' exposure to the tax.

Act now
If you have questions about how the new 3.8% tax may affect you and to discuss tax planning strategies, contact your Ffith Third Private Bank advisor.

Fifth Third does not provide tax advice. Consult with your tax adviser for advice pertinent to you personal situation.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. 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 matter addressed herein.