3.8% Tax- Is that really a big deal?

The answer resoundingly is yes.

It is one of the most controversial aspects of The Affordable Care Act of 2010. .

First, it is a surtax. What this means it is above any other tax assessed on income. So, if your top income tax bracket is 39.6%, this tax put your overall federal rate over 43%. Now, if you add your state tax (Missouri is 6%), you are close to 50% of your taxable income going to the government. So, it is a big deal.

Second, when it applies, it can cause a quick spike in one’s effective tax rate. For example, if your capital gains rate is 15%, the inclusion of the 3.8% surtax can mean in immediate 25% increase in your total tax to 18.8%.

Finally, and most importantly, it’s a big deal because, with advanced planning, it can often be minimized or even avoided.

Who will it affect?

•Single taxpayers with modified adjust gross income of $200,000 or more.

•Married taxpayers with modified adjusted gross incomes of $250,000 or more.

•Married taxpayers filing separately with modified adjusted gross income that exceeds the $250,000 threshold.

•Trusts and estates that file their own returns and have modified adjusted gross income in excess of $11,650.

How is my investment income affected?

Unearned income which means investment income such as interest, dividends, capital gains, rent and royalties are subject to the surtax.

How does it work?

It will apply to either the modified adjusted gross income that exceeds the threshold, or the investment income, whichever is less. In other words, you will owe the 3.8% tax on the amount by which your investment income exceeds the income thresholds. If your wages alone already exceed the income thresholds, you will owe tax on the lesser of net investment income or modified adjusted gross income that exceeds the thresholds.


Are IRA distributions subject to the 3.8% tax?

Technically IRA distributions are not subject to this new 3.8% surtax. However, IRA distributions may increase you modified adjusted gross income. This could, in turn, affect some of your investment income subject to the 3.8% tax.

Are Roth IRA conversions subject to the Medicare surtax?

Taxable income that occurs because of a Roth IRA conversion is not subject to this new 3.8% surtax. Again, the income may increase your modified adjusted gross income which could make some of your investment income subject to this surtax.

How might this affect my home sale?

Currently, the exclusion from the sale of home rules still applies. However, any taxable portion beyond the exclusion would qualify as investment income and could be subject to the surtax.

What does all of this have to do with me and my business?

Plenty.  Consider the ongoing income paid to family members not active in the business. This would include income from a family business operating as an LLC or S Corp where some family members own units or shares, but are not actively involved in the business. The business income that flows through to the non-involved family members is passive income. Therefore, it is considered investment income. Another business concern for business owners comes when/if they decide to sell their business. The 3.8% tax may apply to their regular capital gains tax. So, if the business owner has high enough taxable income, some of the proceeds from a sale of the business could be subject to a tax of nearly 24% (20% capital gains plus 3.8% surtax).

What can I do?

•Be prepared.

•If you are still working, maximize your contributions to pretax retirement strategies to limit your modified adjusted gross income.

•If you are a high wage earner, your employer will not take into account your spouse’s income when figuring the new Medicare tax. So, consider having an additional amount of taxes withdrawn to cover the possible additional taxes.

•If possible, time your income. If you are anticipating a large receipt of investment income, you may want to time the income for a year where your joint income is less.

•Finally, consult a tax planner!