How Does the 3.8% Net Investment Income Surtax Work?
July 24, 2015
Some taxpayers may be struggling with understanding the rules for the 3.8% surtax on net investment income (NII). The tax law provision authorizing this surtax, which went into effect in 2013, was included in the Patient Protection and Affordable Care Act (PPACA). The Supreme Court upheld the PPACA in 2012 but recently agreed to revisit some aspects of the law.
 
Basic premise: The 3.8% surtax applies to the lesser of your NII or the amount by which your modified adjusted gross income (MAGI) exceeds an annual threshold of $200,000 for single filers and $250,000 for married couples filing jointly. The surtax is also imposed on trusts and estates with income above the threshold based on the dollar amount of the highest tax bracket.
 
For this purpose, NII includes interest and dividends; distributions from annuities (other than tax-deferred distributions); rents and royalties; gains from investments in passive activities; trades of financial instruments and commodities; and net capital gains from the sale of property (other than property held in an active trade or business). Significantly, it does not include salary or wages; distributions from IRAs and qualified retirement plans; taxable Social Security income; active trade or business income; self-employment income; gain on the sale of active interests in a partnership, an S corporation or a limited liability company; income from tax-exempt municipal bonds; and tax-deferred income from nonqualified annuities.
 
In some cases, taxpayers may owe the surtax based on NII and in other cases based on the excess MAGI, and in still others they may not have to pay the surtax at all.
 
Example 1: Susan is a single filer with NII of $25,000 in 2014. When she completes her 2014 return, she determines that her MAGI is $250,000. Because the NII of $25,000 is less than the excess MAGI of $50,000, Susan has to pay a surtax of $950 (3.8% of $25,000).
 
Example 2: John is a single filer with NII of $40,000 in 2014. When he completes his 2014 return, he determines that his MAGI is $220,000. Because the excess MAGI of $20,000 is less than the NII of $40,000, John has to pay a surtax of $760 (3.8% of $20,000).
 
Example 3: Mary and Jim are joint filers with NII of $100,000 in 2014. When they complete their 2014 return, they determine that their MAGI is $225,000. Because their MAGI does not exceed the threshold, Mary and Jim do not have to pay a surtax.
 
If you owed the surtax for 2014, there is nothing to do about it now. Going forward, you may consider several strategies for reducing NII and/or MAGI, including postponing large capital gains, selling real estate on an installment basis, investing in tax-free municipal bonds, converting assets in a traditional IRA to a Roth IRA in a low tax year and using a charitable remainder trust, just to name a few. Naturally, you should consider all the ramifications.
 
Coordinate these strategies for 2015 and beyond with assistance from your professional advisers at Faw Casson.
 
 

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