A CERTIFIED FINANCIAL PLANNERTM can help clients save thousands of dollars by helping clients manage this new tax.  Medicare tax has historically been assessed only against earned income. Effective January 1, 2013, a new 3.8% Medicare Tax (the 3.8% tax) will also be levied against unearned income of taxpayers with adjusted gross income (AGI) above thresholds.

How is the 3.8% tax calculated? The tax is assessed against the lesser of net investment income or AGI above the following thresholds:

New 3.8% Medicare Tax AGI Thresholds
Filing Status Threshold
Married Filing Jointly $250,000
Single $200,000
Married Filing Separately $125,000

Example:  A taxpayer filing as “Single” in 2013 has net investment income of $100,000 and adjusted gross income of $250,000. The taxpayer has AGI above the threshold of $50,000 (calculated as $250,000 AGI less threshold AGI of $200,000).  We’ll call that $50,000 “excess AGI”.
Since the $50,000 excess AGI is less than the $100,000 of net investment income, the 3.8% tax is $1,900 (calculated as 3.8% of $50,000).

Traps to Avoid 

  • Don’t transfer investment assets to an Irrevocable Trust in order to avoid the 3.8% – it may backfire!  The threshold amount for trusts and estates is only $11,950.  Compare that to the threshold amounts in the table above.  Why pay 3.8% on hundreds of thousands of dollars if you don’t have to?
  • Be cautious in purchasing annuity contracts with “after-tax” dollars. Distributions of gain from such annuities1 may incur the 3.8% tax.

Tricks to Consider

  • Invest in federally tax-exempt bonds. Interest on municipal bonds is exempt from the 3.8% tax.
  • Transfer investment assets to children with AGIs below the threshold amounts.  Remember the Kiddie Tax – if the children are under the age of 19 (24 if a student), be sure to limit the transfer so that the child’s unearned income is $2,000 or less2.

Stay tuned.  As of this writing, the IRS is developing regulations to clarify the treatment of the new 3.8% tax in S Corporation distributions.  We’ll keep you updated as guidance is published.

Bottom line – financial planners can help clients avoid the traps and take advantage of the tricks in managing the new 3.8% Medicare Tax.

1The IRS refers to annuities purchased with after-tax dollars as “non-qualified” annuities.  The 3.8% tax may apply to distributions from nonqualified annuities. However, distributions from qualified annuities (those purchased in a qualified retirement plan), IRAs, and 403(b) Plans are exempt from the 3.8% tax.

2Unearned income of the child in excess of $2,000 is taxed at the parent’s top marginal income tax rate.