Medicare Surtax on Investment Income Effective January 1, 2013 – Should You Accelerate Income Otherwise Payable in 2013 into 2012?

The Patient Protection and Affordable Care Act, as amended by the Health Care and Educational Reconciliation Act of 2010 (collectively, the PPACA), imposes a Medicare contribution tax on unearned income effective for tax years beginning after December 31, 2012. This new surtax on investment income is in addition to the extra 0.9% in Medicare taxes for high-income earners for wage income also scheduled to go into effect on January 1, 2013. Unlike the surtax on wage income, the new tax on investment income is not a withholding tax, and instead it must be paid by impacted individuals (as well as trusts and estates) when they file their tax returns.

Under new Code section 1411, a 3.8% Medicare tax is levied on unearned income, including interest, dividends, annuities, royalties, rents and capital gains (including gains on the sale of one’s primary residence that exceed the exclusion amount). The tax is also levied on pass-through income from a limited liability company or S-Corporation in which the owners are not active participants. The tax is owed on the unearned income of individuals, trusts and estates.

The new tax applies to the lesser of “net investment income” or the excess of “modified adjusted gross income” over the applicable threshold amount ($250,000 for joint filers or surviving spouses,” $200,000 for single filers and $125,000 for married filing separate filers). Net investment income is investment income reduced by investment expenses (e.g. advisory fees) and modified adjusted income is adjusted income increased by excluded foreign earned income. For example, if an individual has modified adjusted income of $350,000 and has net investment income of $40,000, the tax would be levied on $40,000. Alternatively, if an individual had modified adjusted income of $250,000 and $100,000 of investment income, the tax would be levied on $50,000.

Although the new provision specifically excludes from the definition of “net investment income” distributions from regular or Roth IRAs and distributions from 401(k) and other qualified plans, the new tax should also not apply to “gains” from an employee’s nonqualified plan. Nonqualified plans are not “owned” by the participants, and, therefore, the investment income (which may only be notional) is not the employee’s income. Furthermore, distributions from nonqualified plans are treated as wage income for income tax withholding purposes and, therefore, should not be covered by the new provision.

To the extent possible, individuals should consider taking steps now to accelerate income into 2012 to reduce modified adjusted income and the impact of the Medicare tax increase. For example, those with appreciated assets that they are willing to sell at some point should consider doing so in 2012. The possible increase in capital gains rates in 2013 should also be considered in deciding when to sell appreciated assets. In addition, investors may want to take steps to reduce their passive income and increase investments in municipal bonds in order to reduce the impact of this tax increase. The new law will have a significant impact on tax planning and investment strategies.