Planning for the new 3.8% Medicare tax on unearned income.

• Author: Fava, Karl L.

Effective in 2013, the Health Care and Education Reconciliation Act of 2010 (1) will subject some individuals to a 3.8% Medicare contribution tax on unearned income. This new tax will apply to single taxpayers with a modified adjusted gross income (MAGI) in excess of $200,000 and married taxpayers with a MAGI in excess of $250,000 if filing a joint return, or $125,000 if filing a separate return. The provision is contained in new Sec. 1411, Unearned Income Medicare Contribution. Congress added the provision as a means of raising revenue to pay for health care reform. It targets wealthier taxpayers, as can be seen by the thresholds at which the tax applies.

MAGI is defined as:

adjusted gross income increased by the excess of--

(1) the amount excluded from gross income under section 911(a)(1), over

(2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d) (6) with respect to the amounts described in paragraph (1). (2)

For most individuals, MAGI will be their adjusted gross income unless they are U.S. citizens or residents living abroad and have foreign earned income. The tax is equal to 3.8% of the lesser of net investment income or the amount by which MAGI exceeds the threshold. (3)

Net investment income includes interest, dividends, annuities, royalties, and rents, other than such income that is derived in the ordinary course of a trade or business, less allocable deductions. (4) It also includes income from a passive activity or a trade or business of trading in financial instruments or commodities. (5) It does not include distributions from qualified plans included in Secs. 401(a), 403(a), 403(b), 408, 408A, or 457(b). (6) These sections refer to qualified pension, profit-sharing, and stock bonus plans; qualified annuity plans; annuities purchased by Sec. 501(c) (3) organizations or public schools; individual retirement accounts; Roth individual retirement accounts; and eligible deferred compensation plans, respectively. Net investment income also does not include tax-exempt interest. (7)

Net gain attributable to the disposition of property other than property held in an active trade or business is subject to this tax. (8) Gains from trading in financial instruments or commodities are also included. The taxable gain on the sale of a personal residence in excess of the Sec. 121 exclusion would be included. (9)

Estates and trusts are subject to this tax on the lesser of undistributed net investment income or the excess of adjusted gross income in excess of the highest tax bracket in Sec. 1(e) for the tax year. (10) The tax does not apply to nonresident aliens or a trust in which all of the unexpired interests are devoted to charitable purposes under Sec. 170. (11) "The tax also does not apply to a trust that is exempt from tax under section 501 or a charitable remainder trust exempt from...