Every year, it seems like I talk to more people who are getting an additional tax bill thanks in part to the 3.8% Medicare surtax. They often call me after the fact, looking for ways to minimize the sting of this additional tax which they often weren’t even aware of. Proactive tax planning can help minimize or eliminate the Medicare surtax for many taxpayers.

Don’t be surprised if your stockbroker, financial advisor, and CPA don’t offer tax planning solutions to help you avoid getting walloped by this often-costly tax. Most financial advisors don’t provide tax planning, and for that matter, quite a few aren’t even allowed by their firms to give tax planning guidance. This is a shame, as tax planning is one of the most valuable services financial planners can offer their clients who have high incomes. Many of my clients live in high-tax states like California and New York, making tax planning even more valuable.

California already has some of the highest state-level income taxes in the country, topping out at 13.3%. This is in addition to the top 37% federal tax bracket. If you are a taxpayer in the top federal and California tax brackets, you are also likely going to be subject to an additional 3.8% Medicare surtax on of your investment income.

You may also hear the Medicare surtax referred to as the Obamacare surtax.

How the Medicare Tax Works

The Medicare surtax is only levied on investment income above specific thresholds. For example, if you earn $100,000, you won’t owe any additional taxes via the Medicare surtax.

However, let’s say you are an unmarried taxpayer who makes $180,000 of AGI each year and experienced a one-time capital gain of $100,000 (the investment income) from selling long-held stocks. This would increase your total income to $280,000, making $80,000 of your total income subject to the 3.8% surtax. This would result in you owing roughly $3,040 in extra taxes just from the Medicare surtax.

Your investment income is likely to fluctuate year to year, especially if you sell a home or have equity compensation and realize investment income as your stock options vest. Many people just think of their taxes based on their paychecks or business income. This is likely why many people are surprised the first time they get hit with the Medicare surtax. It is not uncommon for a homeowner in Los Angeles to have a million-dollar capital gain. The same goes for people working in tech who have large amounts of equity compensation.

What Types of Income Are Subject to the Medicare Surtax?

Income sources like interest, dividends, capital gains, rental income, royalties, and even some other passive investment income will be counted.

What Income Is Not Subject to Medicare Surtax?

Generally speaking, you can exclude income from municipal bonds, partnership income, and S Corporations, if you are actively participating. There are also certain types of rental income and some capital gains for selling a business that may be excluded as well.

How To Minimize Your Medicare Surtax

I hope you have such a big income paired with much growth in your investments that you can’t eliminate the Medicare surtax. But with some smart tax planning guidance, you should be able to minimize the amount of Medicare surtax you are required to pay each year.

1. Before you sell a highly appreciated home, consider your income levels and the Medicare surtax. Most Americans will not owe capital gains taxes when they sell their primary residence as you can potentially exclude up to $500,000 ($250,000 for singles) profit on the sale. While $500,000 is a nice exemption, that doesn’t go as far in California as it does almost any other state.
2. Take advantage of tax loss harvesting. I’ve been helping clients with this valuable tax-saving strategy since 2004, and it still amazes me how few so-called financial advisors take the time to do this. The 3.8% Medicare surtax is only levied on net investment income. If you are winning big on one holding, you may have losses you can realize on other holdings to help minimize your net realized capital gains. If I’m making your eyes cross, don’t worry. A good fiduciary financial planner can help take care of it for you.
3. Look for ways to reduce your AGI. The lower your AGI (the number at the bottom of the TAX FORM 1040), the lower the amount of your income will be subject to the 3.8% surtax.
4. Need another reason to contribute to your retirement plan? Making contributions to your 401k, 403b, or Cash Balance Pension will lower your AGI. You can also make charitable contributions from your IRA assets if you are 70 ½ or older.

You Can Escape the Healthcare Surtax with Death

Your heir or heirs will receive a step-up in cost basis when you pass. So, if you hold investments up until you die, there won’t be capital gains taxes or the Medicare surtax on the earnings made prior to your passing. Of course, you will eventually pass, so this is not always a great option.

Source: Forbes

Polk & Associates

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