Part 3: Medicare Tax on Investment Income to Start in 2013

If your income is less than $125,000 a year, then you don’t need to worry about this. But if you are a high income earner, then you should really make sure you check this out.

 

First, there are two things you need to be aware of about taxes on investment income for 2013. One is that the current maximum tax rate on long-term capital gains is scheduled to go up to 20% instead of 15% which it now is (unless Congress decides to act). This is due to the sun setting of the Bush Tax Cuts. It has nothing to do with Obamacare – that’s already in the tax code.

 

The second issue is that higher income folks will also be taxed with an additional 3.8% Medicare contribution tax. (This is what’s in the Obamacare tax package.) This Medicare contribution tax will only apply to higher income earners so those people will also be in the 20% long term capital gain tax as well.

 

What makes the 3.8% Medicare tax kick in? It’s all going to be based upon your adjusted gross income (AGI), kind of like the higher Medicare tax on wages that I wrote about last time. The Medicare tax will kick in if your AGI exceeds:

 

$200,000 if you’re single or filing as head of household
$250,000 if you’re married and filing jointly, or
$125,000 if you use the married filing separate status

 

Before I go on, what exactly do they mean by net investment income? When I was reading the rules, I was thinking about stocks and bonds – that’s what I consider to be investment income. But for this tax, investment income also includes interest, dividends, royalties, annuities, rents, income from passive business activities, income from trading in financial instruments or commodities, and of course, gains from assets held for investment like stocks and other securities. As you can see, this category is much larger than just stocks and bonds. One thing that’s not included here are gains from assets held for business purposes – those won’t be subject to the extra tax.

 

So how does the tax get applied? Now this is where it gets a little funky – the 3.8% tax is going to apply to the lesser of your net investment income or the amount of your AGI in excess of your net investment income. Whew – did you feel something fly right over your head? Trust me I had to read that over a few times to figure out what that meant. And trying to word it differently didn’t always give the right meaning – so let me explain with some examples, okay?

 

Let’s say you’re a married couple and your joint income is $275,000. $225,000 in wages and $50,000 in investment income. You’re going to pay the 3.8% Medicare tax on the investment income that is over the $250,000 threshold. Here’s the math:

 

275,000 – 250,000 = 25,000 (Long version: $275,000 income – $250,000 threshold = $25,000 amount of investment income subject to the extra tax)

 

25,000 x .038 = $950 (Long version: $25,000 investment income subject to Medicare tax x 3.8% Medicare tax rate = $950)

 

So even though you had $50,000 of investment income, you only pay $950, or 3.8% of the 25,000 over the $250,000 threshold.

 

Now let’s say you’re single with those same numbers. Because your threshold is lower, you’d wind up paying the 3.8% tax on all of your investment income. Here, let me show you the math again:

 

275,000 – 200,000 = $75,000 (Long version: $275,000 income – $200,000 threshold = $75,000 amount of investment income that could be subject to the extra tax)

 

But $75,000 is more than the $50,000 investment so we only use the $50,000 to compute the tax.

 

50,000 x .038 = $1,900 (Long version: $50,000 investment income subject to Medicare tax x 3.8% Medicare tax rate = $1,900)

 

Got it?

 

Now remember, I’m just computing the new Medicare tax here – I haven’t taken into account the increase in the long term capital gains rate that is also scheduled to go into effect. And I haven’t even discussed the fact that the tax rate for qualified dividends (which are currently taxed at the long term capital gains rate) is scheduled to change to the ordinary income tax rates. Those changes, if they are not addressed by Congress before the year ends, will have an even larger impact on investment income tax than the Medicare tax and will be affecting persons of all income levels.

 

Remember, these tax changes are scheduled for 2013 so they are not in effect for 2012. You just need to be aware of what’s coming so that you can make intelligent decisions about your investments.