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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Chuck says
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 says
Wondering if RMD “income” comes under that which is to be taxed the 3.8%
Harry Sit says
Hank – Distributions from qualified plans or IRAs are not “net investment income” targeted by the new tax.
nickel says
Very interesting. This does make munis look more attractive for those in affected brackets.
Sammy_M says
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%.
Harry Sit says
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 says
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 says
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 says
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?
Harry Sit says
RSS – From what I can see, yes, it would apply to the portion not categorized as return of capital.
jim says
How will this new tax interact with the AMT? If you pay AMT rather than regular tax, are you out from under this tax?
Harry Sit says
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 says
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
Harry Sit says
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.
Len says
IF A SCHEDULE C IS TRANFORMED TO A PARTNERSHIP (NOT NECESSARILY A FLP) WHERE 50% IS NOT SE INCOME FOR CHILD, IS INCOME COMBINED FOR 3.8% TAX
Jim says
Under Obamacare is the 3.8% unearned income tax applied against social security income or is social security income exempt?
Harry Sit says
@Jim – It applies to interest, dividends, annuities, royalties, rents, and capital gains. When your Social Security income is taxable and it pushes your investment income above the threshold, it’s hard to say whether the tax is on investment income or on Social Security income. If your income isn’t above the threshold, it doesn’t matter.
Jim says
TBF
Thank you for your quick response. Assume we are above the $250,000 filing a joint return. I understand that qualified 401k RMD and IRA income are exempt from the 3.8% Obamacare taxation. Why is there such a lack of clarity on the taxable nature of social security income under Obanacare 3.8% taxation?
Jim
Harry Sit says
@Jim – I guess I wasn’t clear enough about the “push” effect. Suppose you have $200k from pension and 401k withdrawals, and you have $100k from dividends and capital gains, you will pay the 3.8% surtax on $50k (the excess over $250k). You start SS and you get $50k, 85% of which is taxable. It increases your income by $42.5k. Now you will pay the 3.8% surtax on $92.5k of your $100k dividends and capital gains. Although the surtax isn’t officially levied on SS income, it has the same effect.
Now suppose you have $300k from pension and 401k withdrawals and only $10k from dividends and capital gains. You will pay 3.8% surtax on $10k. Adding SS income won’t increase your surtax.
The official answer is no, the 3.8% tax isn’t applied to SS income but it can have the same effect depending on your income composition. The same effect also exists for pension, 401k and IRA withdrawals.
John Cassella says
My pension is income is reported on a K-1
1.Will this be subject to the additional 3.8% investment tax?
2.How will this impact the amt calculation?
3.Will this investment tax paid be taken into consideration when calculating taxes paid?
4. Will 401k withdrwals be subject to the 3.8% tax?
Harry Sit says
John Cassella – (1) Not sure about income on K-1; I would guess no. (2) This tax is on top of AMT. It doesn’t affect how AMT is calculated. (3) For AMT purposes? No. (4) No, but see replies to Jim above.
RobI says
I know this is an old topic but has anyone seen or heard anything recently about inflation based or other adjustments to the thresholds for NIIT going forward? Currently MAGI of $200k(single) and $ 250k (married). This 3.8% extra tax may creep up on some people as interest rates start to rise and may impact other withdrawal planning assumptions.
Also one clarification. Is social security income included in the MAGI income calculation?
Harry Sit says
It’s still current. The NIIT thresholds are not adjusted for inflation. They’re still at $200k (single) and $250k (married filing jointly). Only the taxable portion of the Social Security income is included in the MAGI for NIIT.