3.8% Medicare Tax on Unearned Income in Health Care Reform Bill

March 23, 2010 by TFB

[Updated on April 1, 2010. The proposed legislation has become law.]

Reader Chuck asked about the 3.8% Medicare tax in the health care reform law.

"Does the 3.8% tax on unearned income kick in all at once? You could be looking at an infinity percent marginal rate if you have, say $199,999 in wage income, and $50,000 in capital gains if one extra dollar of income costs $1900 in tax, for example."

The most definitive answer has to come from the law itself. The law containing this provision is HR 4872 Health Care and Education Reconciliation Act of 2010 (full text in PDF). The Act says in Sec. 1411 (page 33 in the PDF, bold emphasis added by me):

"(a) IN GENERAL. – Except as provided in subsection (e) –
       (1) APPLICATION TO INDIVIDUALS. In the case of an individual, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax equal to 3.8 percent of the lesser of –
            (A) net investment income for such taxable year, or
            (B) the excess (if any) of –
                 (i) the modified adjusted gross income for such taxable year, over
                 (ii) the threshold amount."

The threshold amount in Sec. 1411(a)(1)(B)(ii) is the $200,000 single, $250,000 married filing separately number widely reported in the media.

The net investment income in Sec. 1411(a)(1)(A) includes interest, dividends, annuities, royalties, rents, and capital gains. Distributions from qualified plans or IRAs are not included. It does not make any distinction between qualified and ordinary dividends or between short-term and long-term capital gains. All dividends and capital gains are subject to the new Medicare tax equally.

Because interest from muni bonds is not part of the modified adjusted gross income, it will not be affected by this new Medicare tax.

Here are two examples for a married couple filing jointly with $260,000 in modified adjusted gross income (both earned and unearned):

Example 1: Earned income $259k, unearned $1,000. The extra 3.8% Medicare tax applies to only the $1,000 unearned income. Extra tax = $1,000 * 3.8% = $38.

Example 2: Earned income $50k, unearned $210k. The extra 3.8% Medicare tax applies to the excess of MAGI over $250k, which is $50k + $210k – $250k = $10k, because it’s less than the $210k unearned income. Extra tax = $10,000 * 3.8% = $380.

The new Medicare tax on investment income makes muni bond mutual funds more attractive than taxable bonds, CDs, and savings accounts.

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Keywords: Health Care Reform
Filed under: Taxes | Leave a comment

Comments

14 Comments on 3.8% Medicare Tax on Unearned Income in Health Care Reform Bill

Chuck on March 23, 2010 | permalink

Thanks for doing the legwork, there.

So for a single filer, the “lesser of” clause just makes this another tax bracket that goes from $200K to $200K + investment income. So if you have $10,000 in investment income, you’ll have a weird bracket from $200K to $210K where tax is 3.8% higher, then it will go back down again.

As my income grows, it’s becoming more important to understand the difference between income, gross income, adjusted gross income, and modified adjusted gross income, because while all the distinctions seem arbitrary and stupid, they have a big effect on the tax I pay. (My income is nowhere near $250K yet, but I hope someday it will be.)
Hank Fisher on March 23, 2010 | permalink

Wondering if RMD “income” comes under that which is to be taxed the 3.8%
TFB on March 23, 2010 | permalink

Hank – Distributions from qualified plans or IRAs are not “net investment income” targeted by the new tax.
nickel on March 23, 2010 | permalink

Very interesting. This does make munis look more attractive for those in affected brackets.
Sammy_M on March 25, 2010 | permalink

This makes holding munis even more attractive than holding taxable bonds in taxable accounts (depending on your tax bracket), but it does not make munis more attractive than holding equity index funds (that distribute minimal divs and cap gains) in taxable, correct?

TFB, I believe you are in the camp that tax-adjusts your tax deferred porfolio holdings when evaluating your overall asset allocation? If so, what percentage are you using, and will that change with the new medicare tax? Unless a CPI adjustment gets added, I could see getting hit with the add’l medicare tax even in retirement years as I withdrew from my 401K. Therefore, I’m considering bumping up my 20% adjustment on tax deferred holdings to say 25%.
TFB on March 25, 2010 | permalink

Sammy – For the targeted demographic, there are several things going at once: dividend and capital gains tax rate going up; income tax rate going up; deductions are limited; and this Medicare tax on unearned income. There is AMT and state tax too.

In a low interest rate environment, the dividend yield is not that much lower than the bond yield. For at least value equities, it can be more attractive to hold munis in a taxable and hold value equities in a tax advantaged account. I have not done the calculation for a total market index fund yet.

For my tax adjustment, I have been using 1/3. I have not thought about how it should change yet.
Sammy_M on March 25, 2010 | permalink

Appreciate your thoughts. It definitely makes sense to be careful where you’re placing your value-oriented equity funds. I may have to rethink my placement of EFV and IJS going forward.

I guess I’d have to see the math, but I’m skeptical that these changes will truly up-end the conventional wisdom of holding taxable bonds in tax advantaged and equity indexes in taxable.

It seems if more demand for munis results, yields will just adjust downward and the cost of capital reduce for the muni govts. So, you’re tax bill might be lower if you use munis, but your after-tax returns might be lower as well.
John Leney on March 26, 2010 | permalink

I’m I wrong in thinking that a successful landlord of a fully depreciated apartment complex were the rents average $800-900/mo could be facing a $400/unit medicare tax/fee per year. And if he were to ‘pass along this cost to make himself whole’ would have to raise his rents $600-$700/yr?
RSS on March 29, 2010 | permalink

Does the 3.8% tax on unearned income apply to profit distributions to investors who own units in master limited partnerships engaged in operating oil and gas pipelines?
TFB on March 29, 2010 | permalink

RSS – From what I can see, yes, it would apply to the portion not categorized as return of capital.
jim on May 18, 2010 | permalink

How will this new tax interact with the AMT? If you pay AMT rather than regular tax, are you out from under this tax?
TFB on May 18, 2010 | permalink

jim – Before I see more details, I believe AMT will absorb this additional tax in full or in part. That is, this will increase the regular tax but it does not increase AMT. If AMT is still higher, your tax is unchanged. If the increase causes your regular tax to exceed your AMT, then your tax will increase by the difference.
Judy Curtis on May 24, 2010 | permalink

I understand the 3.8% medicare tax will include interest, dividends, capital gins, annuities, royalties and passive rental income. Can you tell me if a Federal retirement annuity would be excluded? Thanks
TFB on May 24, 2010 | permalink

Judy – What is this Federal retirement annuity? If it’s a pension plan from which you get a monthly income because you worked for the employer for so many years, it’s not included.