Planning for the new Medicare taxes.

• Author: Knittel, David

There are now two more taxes for tax practitioners to consider while planning for their clients' year-end liability. The recently passed 2010 health care reform legislation (the Patient Protection and Affordable Care Act, PL. 111-148, and the Health Care and Education Reconciliation Act, P.L. 111-152) added two additional Medicare taxes intended to help pay for the new legislation. This item looks at the details of both the 3.8% investment income tax and the 0.9% hospital insurance tax increase and reviews some of the effects they will have on estimated taxes and tax planning.

Medicare Investment Income Tax

The details of the Medicare investment tax are not nearly as complicated as are many of the other provisions of the new laws. In brief, starting in 2013 there will be a 3.8% tax levied on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount. The threshold is $250,000 for married couples filing jointly, $125,000 for married filing separately, and $200,000 for all other returns.

One result of the new tax is an increase in the marriage penalty. Two cohabitating single taxpayers can earn $200,000 each for a total of $400,000 before reaching the threshold, while married couples will reach $250,000 sooner, which complicates the calculation of estimated taxes for married couples (explained below).

The tax is focused solely on investment income. A taxpayer with no investment income will not owe the additional 3.8% regardless of how much his or her MAGI exceeds the threshold. On the other hand, a single taxpayer with MAGI of less than $200,000 will not pay the additional 3.8% even if his or her entire earnings consist of only investment income.

Example 1: J, a single taxpayer who has MAGI of $230,000 and investment income of $50,000, will owe $1,140 (0.038 x $30,000). The charge is 3.8% on the lesser of his investment income ($50,000) or his MAGI in excess of $200,000 ($30,000). However, if J has MAGI of $230,000 but has investment income of only $20,000, he will owe $760 (0.038 x $20,000), calculated as 3.8% of the lesser of investment income (now $20,000) or MAGI in excess of $200,000 ($30,000). The definition of investment income includes such items as interest, dividends, and capital gains, as might have been expected. Investment income will also include annuities, royalties, and any income that would fall under the passive activity rules of Sec. 469, including rents and...