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Considerations for the Medicare Surtax on Investment Income

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Prior to 2013, Medicare taxes had only been imposed on earned income.

That is, income earned through employee wages or self-employment earnings. However, beginning in 2013, to help fund the Affordable Care Act (ACA), a 3.8% Medicare surtax was enacted into law on all investment income above certain income level thresholds. The surtax applies to married couples filing jointly with an adjusted gross income (AGI) above $250,000 and single filers with an AGI above $200,000. The surtax applies only to the amount of investment income in excess the threshold amount.

For example, if you and your spouse earn wages of $260,000 and have $10,000 of investment income throughout the year, your additional Medicare tax will be 3.8% x $10,000, or $380. Investment income includes dividends, interest, capital gains, annuity income, royalties and rental income.

Related: How to Start a Retirement Plan for Your Small Business

So, if you believe your level of income will surpass the thresholds established, what can you do to aid in reducing, or avoiding, your exposure to the Medicare surtax on investment income? The goal of the strategies below are to reduce your adjusted income.

These strategies will have the dual effect of avoiding or reducing the Medicare surtax as well as your overall tax burden due to the reduction in your taxable income.

  • Increase pretax deferrals to workplace retirement plans, such as 401ks and 403bs. These increased deferrals lower your gross salary, which in turn lower your AGI. For 2018, employees age 49 and younger can contribute up to $18,500 and those 50 and above may contribute an additional $6,500.
  • If you are self-employed or own a small business, consider opening a SEP IRA or Solo 401k. Like traditional workplace retirement plans, deferring income to these plans will reduce your AGI, but your annual contribution amount will need to be calculated based on your net Schedule C income.
  • If you are covered by a high deductible health plan, consider increasing or maxing your Health Savings Account contribution annually. Current limits are $3,450 for individuals and $6,900 for families.
  • Consider other benefits your employer offers that will result in a reduction in your gross wages through pretax payroll deductions, such as childcare and healthcare flexible spending accounts.
  • Be mindful of the investments you select in your taxable investment accounts. Selecting investments which distribute large capital gains and pay high dividends or realizing capital gains can have a material effect on the taxes you will owe. Thus, portfolio construction is key, and by implementing a disciplined investment strategy you can increase the overall tax efficiency of your portfolio.

Often, investors focus solely on the rate of return that is presented on their investment reports without considering the negative impact taxes can have. So, have you been impacted in the past by the Medicare surtax or do you think you may be in coming years? Luckily, there are several strategies available to you and ongoing tax planning can help improve your financial plan’s overall tax efficiency.

 

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