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.