Starting in 2013, high-income taxpayers will face new taxes-a 3.8% Medicare contribution tax on net investment income and a 0.9% additional Medicare tax on wage and self-employment income. Here's an overview of the two new taxes and what they will mean to you.
3.8% Medicare contribution tax. This new tax will only affect taxpayers whose adjusted gross income (AGI) exceeds $250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for a married individuals filing separately. These threshold amounts aren't indexed for inflation. Thus, as time goes by, inflation will cause more taxpayers to become subject to the 3.8% tax.
If your AGI is above the threshold that applies to you ($250,000, $200,000 or $125,000), the 3.8% tax will apply to the lesser of (1) your net investment income for the tax year or (2) the excess of your AGI for the tax year over your threshold amount. This tax will be in addition to the income tax that applies to that same income.
Take, for example, a married couple that has AGI of $270,000 for 2013, of which $100,000 is net investment income. They would pay a Medicare contribution tax on only the $20,000 amount by which their AGI exceeds their threshold amount of $250,000. That is because the $20,000 excess is less than their net investment income of $100,000. Thus, the couple's Medicare contribution tax would be $760 ($20,000 × 3.8%).
Now assume that the couple's AGI was $350,000. Because their AGI exceeds their threshold amount by $100,000, they would pay a Medicare contribution tax on their full $100,000 of net investment income. Their Medicare contribution tax would then be $3,800 ($100,000 × 3.8%).
What is net investment income? The "net investment income" that is subject to the 3.8% tax consists of interest, dividends, annuities, royalties, rents, and net gains from property sales. Income from an active trade or business isn't included in net investment income, nor is wage income.
However, passive business income is subject to the Medicare contribution tax. Thus, rents from an active trade or business aren't subject to the tax, but rents from a passive activity are subject to it. Income from a business of trading financial instruments or commodities is also included in net investment income.
Income that is exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the 3.8% Medicare contribution tax. Thus, switching some of your taxable investments into tax-exempt bonds can reduce your exposure to the 3.8% tax. Of course, this should be done with due regard to your income needs and investment considerations.
Home sales. Many people have asked how the 3.8% tax applies to home sales. If you sell your main home, you may be able to exclude up to $250,000 of gain, or up to $500,000 for joint filers, when figuring your income tax. This excluded gain won't be subject to the 3.8% Medicare contribution tax.
However, gain that exceeds the limit on the exclusion will be subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn't qualify for the income tax exclusion, will also be subject to the Medicare contribution tax.
Retirement plan distributions. Distributions from qualified retirement plans, such as pension plans and IRAs, aren't subject to the Medicare contribution tax. However, those distributions may push your AGI over the threshold that would cause other types of investment income to be subject to the tax.
Estimated tax. The Medicare contribution tax must be included in the calculation of estimated tax that you owe. Thus, if you will be subject to the tax, you may have to make or increase your estimated tax payments to avoid a penalty.