Planning for the 3.8% Medicare Surtax

Planning for the 3.8% Medicare Surtax

Published in Bradenton Herald: October 29, 2013

By GARDNER SHERRILL | Investor’s Column


October 29, 2013

Potrait of Gardner Sherrill

Planning for the 3.8% Medicare Surtax

As "Obamacare" or the Affordable Care Act of 2010 is well underway this month it is a good time to address the tax aspects that are funding a portion of the new law. October is also a good time to review your tax planning before year-end and take advantage of opportunities to defer or eliminate unnecessary taxes.

The new law imposes a 0.9% Medicare surtax on earned income and a 3.8% Medicare surtax on unearned income. The difference essentially is income derived from a job versus income derived from investments. The tax only applies to "high income" earners as defined as individuals with Modified Adjusted Gross Income in excess of $200,000 or couples with MAGI in excess of $250,000.

Planning Opportunities - Medicare Tax Crossover Zone

The "Cross-over Zone" applies when investment income pushes through the MAGI limitations causing a portion to be taxed at the higher 3.8% medicare surtax rate. For example: Diane is a single woman who has a salary of $150,000 and investment income of $50,000. Diane has MAGI of $200,000 and therefore is not exposed to the surtax. If however she received a year-end bonus of $25,000, she would now have MAGI of $225,000 and half of her investment income would now be exposed to the surtax. If she additionally incurred $25,000 of capital gains, she again would expose another $25,000 to the surtax. If you are in the cross-over zone you might find some of the below strategies helpful in reducing your exposure to the 3.8 percent surtax.

Reducing Earned Income

3.8% Medicare Surtax

1. Maximize Qualified

& Non-Qualified Plans in addition to IRA Contributions. Pre-tax contributions to a qualified retirement plan and/or IRA will reduce your taxable income. Increase your contributions and take advantage of catch up provisions if you are more than 50 years old.

2. Health Savings Account: Contributions to a health savings account are deductible from income.

3. Charitable Gifting: A gift to charity will reduce adjusted gross income subject to MAGI limitations. There are many charitable strategies to consider depending on your needs and objectives. Some will target the current year's earned income while others can reduce your ongoing investment income that is exposed to the 3.8% medicare surtax.

Reducing investment Income as a strategy

1. Defer or accelerate capital gain recognition. If you know your investment income is low this year, you may consider taking capital gains this year to the extent it doesn't take you above the zone. If on the other hand you are above the zone you may choose to defer gains until the next year.

2. Municipal Bonds: Municipal income is exempt from the surcharge and so you may want to add 3.8 percent in calculating your Taxable Equivalent Yield when above the cross-over zone.

3. Life Insurance: The inside buildup of life insurance cash surrender value is not subject to the new Medicare tax, nor are life insurance proceeds that are excluded from income tax. When it comes time to extract money from a policy, distributions come first from contributions which are not subject to the tax. When distributions exceed contributions you can borrow against the earned income thereby avoiding the surtax.

4. Roth IRA Conversion. While converting a Traditional IRA to a Roth IRA is a taxable event, Roth IRA's can offer more flexibility than Traditional IRAs due to their tax-free nature and absence of required minimum distributions. If you make a conversion, consider paying the tax liability from a source other than the IRA. If the tax is paid from a taxable portfolio producing investment income, that portion of the portfolio used will be shielded from the surtax.

5. Non-deductible IRA Contribution: IRA distributions are not taken into consideration for investment income calculations. So even if you don't have the ability to take a current income tax deduction for the IRA Contribution this year, you will still achieve the ability to draw distributions down the road that are exempt from the Medicare Tax Surcharge. A back door Roth might then be a further consideration.

Investment caveat

Shifting investments that reduces expected return by more than the tax assessed can result in less overall wealth.

Additionally shifting income can unintentionally cause you to bump up a tax bracket again resulting in less wealth.

Overall, as you manage your tax planning for the year end, the new 3.8% Medicare surtax on unearned income creates a new hurdle to consider. Given some time and attention there are some good opportunities for a taxpayer to plan for some potential minimization strategies.

Gardner Sherrill, MBA, helps plan for a successful retirement. To learn more visit This information is not intended to be a substitute for specific individualized tax or legal advice. Individual circumstances will vary. Please see your tax professional regarding your specific situation.

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