Planning for the New 3.8% Surtax on Net Investment Income & Gains

December 2012
Author:  Robert Conner

Robert Conner



Health Care
Manufacturing & Distribution

1801 California Street, Suite 2900
Denver, CO 80202-2606


In order to develop an effective tax plan, one often must weigh planning strategies under an array of possibilities in order to determine the best course of action. This is especially true in the current economic environment, given the uncertainty over how Congress and President Obama will deal with the “fiscal cliff.” One certainty we can plan for is the new 3.8 percent Medicare surtax on net investment income.


Historically, taxpayers were not required to pay Medicare tax on net investment earnings. However, with the passage of the Affordable Care Act, beginning January 1, 2013, certain individuals, estates and trusts will find themselves subject to a 3.8 percent Medicare surtax on the lesser of net investment income (undistributed net investment income for trusts and estates) or modified adjusted gross income less an applicable threshold.

The modified adjusted gross income threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, $200,000 for individual taxpayers and head of households, and for estates and trusts, the amount at which the highest tax bracket begins ($11,650 for 2012).

Net investment income is defined as the sum of the following:

  • Gross income from interest, dividends, annuities, royalties and rents, other than income derived in the ordinary course of a trade or business to which the tax does not apply
  • Other gross income from trades or businesses to which the tax applies, e.g., passive activities
  • Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply

The following is then subtracted:

  • Deductions properly allocable to such gross income or net gain

Planning Strategies

It is important to remember the 3.8 percent Medicare surtax only applies if a taxpayer has net investment income and modified adjusted gross income in excess of the applicable threshold. Therefore, the following planning considerations revolve largely around strategies intended to properly time and control modified adjusted gross income and net investment income.

Investments, Gains & Losses

Planning Tip #1:   If planning to sell appreciated securities in the near future, consider recognizing the capital gains prior to 2013. This is often referred to as “gain harvesting.” Because the wash-sale rules do not apply to gains, a taxpayer could sell a security at a gain prior to 2013 and buy it right back to accomplish a step-up in basis. In doing so, the gain would be taxed at the preferential Bush-era tax rates and not be subject to the 3.8 percent Medicare surtax. In addition, the step-up would help alleviate a future 3.8 percent Medicare surtax burden.  

Planning Tip #2:   Taxpayers finding themselves in a net-capital gain situation for 2012 might consider deferring the recognition of capital losses until after 2012. This would preserve the capital losses for use against future capital gains that might otherwise be subject to the 3.8 percent Medicare surtax and potentially higher capital gain rates.

Planning Tip #3:   For installment sale gains subject to the 3.8 percent Medicare surtax, taxpayers may consider electing out of installment sale treatment for 2012 sales or attempting to accelerate the payment of an existing installment note. This would require analyzing many tax and nontax factors such as cash flow needs, anticipated future tax rates and time value of money.

Planning Tip #4:   Consider donating appreciated securities to charity rather than cash. Doing so will generate a charitable deduction equal to the fair market value of the security, avoid capital gains tax on the built-in gain of the security and, if donated after 2012, avoid the 3.8 percent Medicare surtax on the gain. Taxpayers could then use the cash they would have otherwise donated and repurchase the security to achieve a step-up in basis.

Planning Tip #5:   Taxpayers may want to rebalance their investment portfolio to emphasize growth assets over dividend-paying assets. Taxpayers also may want to consider favoring investments in tax-exempt bonds. Taxpayers considering this strategy should work with their tax and investment advisors to determine if the rebalanced portfolio would work with their overall wealth plan strategy.

Planning Tip #6:   Taxpayers with 2012 investment interest expense in excess of interest income and nonqualified dividends may want to forgo the election to treat 2012 qualified dividends and long-term capital gains as investment income. Foregoing the election in certain circumstances could preserve an investment interest expense carryforward to 2013 to offset net investment income that otherwise may be subject to the 3.8 percent Medicare surtax.

Modified Adjusted Gross Income Planning

Planning Tip #1:   Consider accelerating bonuses, commissions, nonqualified stock options and other forms of compensation into 2012. This will not only prevent the compensation from potentially being subject to the additional 0.9% Medicare tax on high-income earners in 2013, but could help alleviate a 3.8 percent Medicare surtax liability in 2013.

For example, John, a single taxpayer, has regular salary of $150,000 and investment income of $50,000 during 2012. John’s employer has approved a year-end bonus of $50,000 that at John’s discretion can be paid either with the last payroll of 2012 or the first payroll of 2013. John anticipates his 2013 regular salary and investment income will be the same as 2012 amounts. If John accelerates his bonus payment into 2012, his 2013 net investment surtax liability will be zero. However, if he defers payment of the bonus into 2013, his net investment surtax liability will be $1,900 ($50,000 x 3.8%).

Planning Tip #2:   Consider converting traditional IRAs to Roth IRAs prior to 2013. Doing so allows future account earnings to grow tax-free and eliminates the need to make required minimum distributions. Conversions are fully taxable in the year of conversion, so in addition to the future 3.8 percent Medicare surtax planning, a variety of factors needs to be considered, including the following:

  • What will be the tax rate on IRA withdrawals if made over a period of years in the future?
  • How does the current-year tax rate on conversion compare with anticipated future tax rates?
  • Can the tax on the IRA conversion be paid from a source other than IRA funds?

Planning Tip #3:   Taxpayers who own an S corporation previously taxed as a C corporation that have accumulated earnings and profits should consider paying out the C corp earnings and profits as a dividend in 2012. Doing so will potentially reduce future modified adjusted gross income as well as lock in the dividend income at the preferential Bush-era tax rates.

Trade or Business Activity Planning

Planning Tip #1:   Revisit converting an active trade or business to an S corp. S corp owner earnings in excess of amounts paid out as reasonable compensation will not be subject to the 3.8 percent Medicare surtax, the 0.9 percent Medicare tax on high-income earners or self-employment tax.

Planning Tip #2:   Review current grouping elections. Taxpayers with multiple activities often find it difficult to meet the material participation standards necessary to be considered nonpassive with respect to their activities. The regulations may provide relief  by permitting taxpayers to group activities that represent an appropriate economic unit for purposes of measuring material participation. Passive activity planning is a complicated tax area and should be discussed with your tax advisor.

Estate & Trust Planning

Planning Tip #1:   Consider the benefit of distributing income to beneficiaries. Certain trusts and estates will be subject to the 3.8 percent Medicare surtax to the extent that undistributed net investment income exceeds a relatively low threshold (approximately $12,000). On the other hand, beneficiaries have a much higher threshold for purposes of imposing the tax. Therefore, it may make sense for fiduciaries to distribute the net investment income the entity receives where the discretion to do so exists.

Planning Tip #2:   Estates of a decedent who dies any time between December 1, 2011, and November 30, 2012, should consider choosing a fiscal year that ends November 30, 2012. This will prevent any income reported during the December 1, 2012, through November 30, 2013, period from being subject to the 3.8 percent Medicare surtax. The entity also will enjoy the preferential Bush-era tax rates for the December 1, 2012, through November 30, 2013, period.

Planning Tip #3:   Consider making an election to treat the distribution of appreciated property to a beneficiary as taxable gain in 2012. This will lock in the gain at the preferential Bush-era tax rates and prevent the gain from being subject to the 3.8 percent Medicare surtax in future years.

While there is no one-size-fits-all solution when it comes to effective tax planning, taxpayers must educate themselves on the available options, evaluate strategies under an array of different possibilities and make the most informed decision possible with respect to a course of action.

The strategies discussed above are aimed at planning for the new 3.8 percent Medicare surtax. However, the implementation of these strategies could have carryover effects on other facets of your income tax picture. To learn more about how these strategies may be implemented into your overall tax plan, contact your BKD advisor.

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