It appears that the 3.8% Medicare surtax on net investment income (NII), which was included in the controversial Patient Protection and Affordable Care Act (aka Obamacare), is here to stay.
Strategy: Analyze your exposure to the surtax. If you estimate you’ll have to pay the surtax for 2014, there’s little you can do about it now. But 2015 is another story.
Specifically, by taking steps to lower your NII or your modified adjusted gross income (MAGI) this year, you may be able to minimize the impact of the surtax or even avoid it altogether.
Here’s the whole story: The 3.8% surtax applies to the lesser of NII or the excess MAGI over the applicable annual threshold. The threshold is $200,000 for unmarried filers and $250,000 for married joint-filing couples. NII includes interest and dividends, capital gains, most royalty income, most rental property income and gains and income and gains from passive business activities. Certain other income items, like taxable IRA and qualified retirement plan distributions, self-employment income, and income from nonpassive business activities, are excluded.
As a result, if either your NII or your MAGI is too high, you owe the surtax.
Example 1: A single filer has $25,000 of NII and an MAGI of $210,000 in 2014. Because the excess MAGI of $10,000 is lower than the $25,000 in NII, the single filer owes a surtax of $380 (3.8% of $10,000).
Example 2: Joint filers have NII of $50,000 and an MAGI of $350,000 in 2014. Because the NII of $50,000 is lower than the excess MAGI of $100,000, the joint filers owe a surtax of $1,900 (3.8% of $50,000).
What can you do for 2015 and beyond? Here are several ideas for reducing your annual NII.
- Invest in tax-free municipal bonds. The income doesn’t count as NII.
- Switch from dividend-paying stocks to growth stocks. Hold onto the stocks until you’re in a year when you are not exposed to the NII surtax.
- Use tax-deferred annuities to postpone or avoid exposure to the NII surtax.
- Purchase rental real estate that will generate passive losses to offset passive income.
Next, consider employing the following strategies to lower your MAGI.
- Harvest capital losses from securities sales. The losses can reduce your MAGI by offsetting your capital gains plus up to $3,000 of ordinary income.
- Arrange an installment sale of real estate. By spreading out your gain over several years, you might keep MAGI below the threshold.
- Convert traditional IRA funds to a Roth. There’s a one-time tax hit, but future tax-free payouts won’t increase your MAGI. (IRA distributions don’t count as NII.)
- Swap property through a like-kind exchange. There’s no current tax liability except to the extent you receive “boot” in the deal.
Tip: Self-employed individuals may still reduce the surtax for 2014.