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Plan Now to Reduce New Tax on Investment Income

By Marcia Richards Suelzer, MA, JD | July 17, 2012

The Affordable Care Act (ACA) imposes a new 3.8 percent Medicare contribution tax on unearned income beginning in 2013.


The 3.8 percent Unearned Income Medicare Contribution Tax (UIMCT) will be imposed in addition to any increase in the dividends, capital gains and ordinary income rates that will be triggered if the Bush-era tax rates expire at the end of 2012. For example, the capital gains tax is scheduled to revert to 20 percent for most taxpayers. If the UIMCT applies, the capital gains tax rate will be 23.8 percent.

Tax Based on Net Investment Income or Income Above MAGI Threshold

This 3.8 percent tax is imposed on the lesser of an individual's

  • net investment income for the year or
  • modified adjusted gross income (MAGI) over $200,000 ($250,000 for married couples filing a joint return; $125,000 for a married individual filing a separate return.)

The thresholds for the UIMCT have the same marriage penalty as the 0.9 percent Medicare contribution tax surcharge.

For example, Mary and Larry are married. Each earns $165,000. They also have $30,000 in investment income. Their MAGI is over the threshold of $250,000. They will owe 3.8 percent UIMCT because their $30,000 net investment income is less than $110,000 (their $360,000 MAGI minus the $250,000 filing threshold).

In contrast, Freddie and Teddy live together but are not married. All other facts are the same. Freddie and Teddy are not liable for the UIMCT. Neither of them reaches the $200,000 threshold that triggers tax liability.

Modified Adjusted Gross Income Defined. For most people, their Modified Adjusted Gross Income (MAGI) for purposes of this tax will be the amount of the Adjusted Gross Income (AGI) shown on Form 1040, Line 38. Those who worked abroad and excluded foreign income or foreign housing allowances from their AGI must include these amounts in their MAGI.

Unlike the 0.9 percent Medicare surcharge on compensation and self-employment income, all types of income are counted in determining whether the MAGI threshold is reached.


Linda, an unmarried taxpayer, has $180,000 in wage income and $30,000 in passive investment income. Even though her MAGI is $210,000, she will not need to pay the 0.9 percent Medicare surcharge because her earned income is under $200,000. However, she will need to pay the 3.8 percent tax on $10,000 ($210,000 MAGI - $200,000 threshold) = $10,000) because that is less than her $30,000 net investment income.

Net investment income defined. This tax targets investment, or passive, income. The following items are considered investment income:

  • gross income (not generated in the ordinary course of a non-passive business activity) from
    • interest,
    • dividends,
    • annuities,
    • royalties and
    • rents
  • any passive trade or business income or income from a business engaged in trading financial instruments or commodities
  • net gain attributable to the disposition of property (other than property held in a non-passive trade or business), including gains from the sale of a home that exceeds the $250,000 ($500,000 for joint returns) exclusion.

Business owners will be relieved to see the "active trade or business" exception. This enables the business owner who actively participates in the business (and most small business owners do) to pay a dividend from the business without triggering the UIMCT.

Think Ahead

Paying a dividend to active participants in the business can help avoid the Medicare tax surcharge imposed on wages and salaries over $200,000 per year ($250,000 for married taxpayers, filing jointly; $125,000 for married, filing separately). By planning for a series of dividends and taking the steps necessary to formalize these payments, you can lower your exposure to the 0.9 percent surtax.

Start Planning Now to Minimize Your Tax Liability

Although the law could be changed following the upcoming November elections, the most prudent strategy is to start planning now as if the tax were here to stay. (On the plus side, many of the strategies that will protect you from the UIMCT will also help lessen the tax bite that will occur if the Bush-era tax rates expire as scheduled at the end of the year.) 

In order to avoid the tax, you will need to employ a variety of strategies that reduce the amount of your modified adjusted gross income, lower the amount of your net investment income or do both. What's more, you'll need to look at your investment portfolio and your retirement plans to see what options may make sense for you.

Lower your net investment income. If you are likely to hit the income threshold, you will want to consider options that will reduce your net investment income. It may make sense to adjust your portfolio to decrease your investment in traditional, dividend-paying instruments and increase your holdings in the following:

  • long-term growth stocks, ones that do not pay dividends;
  • tax-deferred annuities; and
  • tax-exempt obligations.
Work Smart

Discuss the following strategy with your financial adviser: liquidate investments with substantial appreciation before the end of 2012 and reinvest in either the same stocks or shift to one of the investment options noted above. 

You will owe capital gains tax as a result of the sale, but this gain would be taxed at the current capital gains rate of 15 percent, rather than at 23.8 percent (the capital gains rate scheduled for 2013 plus the UIMCT).

If you have a substantial gain, the savings could be signficant: $8,800 in taxes saved for every $100,000 in gains ($100,000 * 0.15=$15,000 versus $100,000 * 0.238=$23,800). However, tax savings must not be your only consideration—you need to consider all aspects of your financial picture.

Carefully structure capital asset sales. If you are anticipating the sale of nonbusiness or passive business capital assets, timing will be everything. Gain from the sale of a residence is specifically included in the reach of the law. Any gain exceeding the amount that can be excluded from income ($250,000 per individual; $500,000 for married co-owners who file a joint return) will be taxed. Gain for the sale of vacation or second homes generally will be fully taxable. Also, the sale of assets used in a passive business activity—which will include most real estate activities—are also subject to the UIMCT.

If, and only if, you are planning to dispose of non-business or passive business assets, it will be to your advantage to close the sale before the end of 2012. If you can't close before year's end, then you should consider structuring the transaction as an installment sale, thus spreading out the investment income over a number of years.

Work Smart

Do not let tax considerations trump sound business and financial planning. Tax laws change all the time. Rushing to liquidate assets that you would otherwise continue to hold may prove more harmful than beneficial.

Minimize passive activity income. The new law adopts "material participation" tests for passive activity that are used for the passive activity loss rules. Basically, you will have passive income if you are not regularly and continuously involved in the activity in a substantial manner.


The most obvious type of passive activity is the ownership of real estate for profit, where the individual is simply an investor in an entity that holds the property.

There are a number of tests used to establish material participation in the business, such as participating in the activity for more than 500 hours in a year. Although most small business owners will have no difficulty meeting this test with regards to their primary business, those who are semi-retired should check to see if they can still meet the tests. Also, those who are limited partners should consult a business/tax attorney to evaluate whether a limited partnership interest formed years ago still makes sense. (Many limited partnerships were created for asset protection purposes before the use of limited liability companies skyrocketed.)

Retirement Planning Becomes More Complicated

Retirement planning illustrates the balancing act involved in sound tax planning. You need to balance the value of pre-tax dollar contributions against the value of excluding distributions from your income.

Impact of distributions. Retirement plan distributions--whether funded from pre- or post-tax dollars--are not subject to UIMCT.

However, a distribution from a plan funded with pre-tax dollars--such as a traditional IRA or 401(k) plan--is taxable income. So, even though you do not pay the 3.8 percent Medicare tax on the distribution, it will increase your MAGI in the year you receive it. This might be enough to push you over the threshold and subject your other unearned income to the 3.8 percent tax. On the other hand, distributions from a Roth plan are not included in income. Therefore, these distributions do not increase your MAGI in the year of the distribution.


Mark, an unmarried taxpayer, has $100,000 of wage and bonus income in 2013. He also has $50,000 of taxable gain from the sale of his home and took a $75,000 distribution from his traditional 401(k) plan. Although the $75,000 distribution is not subject to the UIMCT, it does count in his income for the year. Thus, he is over the $200,000 threshold and will be liable for 3.8 percent in Medicare tax on the lesser of this MAGI over the threshold or the amount of investment income.

In this case, Mark's MAGI in excess of the threshold is $25,000, while his investment income is $50,000. Thus, he will owe $950 ($25,000 * 0.038) in UIMCT.

Had the distribution been from a Roth 401(k) plan, Mark would not owe any UIMCT because the distribution would not be included in MAGI.

Retirement plan contributions. For purposes of UIMCT planning, think of the rules governing retirement plan contributions as the opposite of the rules governing distributions. Retirement plan contributions using pre-tax dollars (such as those made to a traditional IRS or 401(k)) lower your MAGI in the year you make the contribution. This can help you avoid both the 3.9 percent Medicare tax on unearned income and the 0.9 percent surcharge on wages and self-employment income. In contrast, contributions to a Roth plan do nothing to reduce your MAGI in the year of the contribution.

Striking a balance. You will want to work with a tax professional to do the math for your situation. And, you might want to explore converting your traditional plans to Roth plans before the end of 2012. Then, going forward, funding a new traditional 401(k) with pre-tax dollars.  This strategy provides two key advantages:

  • Any distributions from the Roth will not count toward your MAGI for purposes of the UIMCT. 
  • The contributions to the traditional plan lowers lower your compensation amount, reducing your exposure to the 0.9 percent Medicare surcharge.


Roth conversions carry their own tax consequences. It is essential that you work with a tax professional will take your entire financial situation into account and then structure any transactions in the most advantageous manner.

Consider Your Overall Financial Situation

This article suggests a number of strategies that you should begin to consider in order to protect your wealth from the reach of the UIMCT. However, this new tax is only a minor aspect of your overall financial picture. Taxes should never be a sole driver in financial decisions. Having a clear vision for your business and your financial future and working with qualified tax professionals will help keep you on track to meet your goals—regardless of whether the UIMCT goes into effect or is repealed after the November elections.

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