Determining whether you owe the Medicare surtax

The 3.8% Net Investment Income Tax (NIIT), also known as the Medicare surtax, applies to what the IRS calls “certain unearned income.” This category includes taxable interest, ordinary dividends, and capital gains among other items; however, it excludes salaries, bonuses and self-employment income, which may be subject to a 0.9% additional Medicare tax if above certain income levels.

The surtax applies to the smaller of net investment income (NII) or modified adjusted gross income (MAGI) that exceeds certain thresholds.


Doing the math for NII

Before you can figure out your NII, you need to know what commonly counts as investment income: interest from investments (except interest from tax-exempt municipal bonds), dividends, certain capital gains, rental and royalty income, nonqualified annuities, and income from passive businesses in which you don’t participate on a regular, continuous, and substantial basis. (Pensions, Social Security benefits, and qualified retirement plan and IRA distributions don’t count toward your investment income.)

Next, add up certain allocated expenses you paid while investing to generate the income: investment interest expense (but not interest from your personal mortgage), investment advisory and brokerage fees, expenses related to rental and royalty income, tax prep fees, state and local income taxes, and fiduciary fees (for an estate or trust). Then subtract your expenses from your investment income to get your NII.


Doing the math for MAGI

If you haven’t excluded any foreign earned income, your MAGI is generally the same as your AGI. The IRS defines AGI as gross income reduced by certain adjustments.) For Medicare surtax purposes, according to the IRS, calculate your MAGI by adding back to your adjusted gross income (AGI) some deductions relating to certain foreign earned income.

Keep in mind that required distributions from traditional IRAs and qualified retirement plans count toward your MAGI, but those from Roth IRAs and Roth 401(k)s don’t.

The Medicare surtax’s MAGI thresholds are:

  • Single taxpayer or head of household with MAGI, including net investment income, exceeding $200,000.
  • Married filing jointly or qualifying widow(er) with a MAGI exceeding $250,000.
  • Married filing separately with an individual MAGI exceeding $125,000.
These threshold amounts are not indexed for inflation.

Trusts and estates with the lesser of undistributed NII or AGI of more than $12,300 for the 2015 tax year are also subject to the Medicare surtax.


Managing your NII

Jacklin Youssef
Jacklin Youssef
When it comes to investment income, “the Medicare surtax doesn’t change Vanguard’s asset location recommendations,” said Jacklin Youssef, a senior wealth planner with Vanguard Advice Services Group. “It’s a good practice to hold tax-inefficient assets in tax-advantaged accounts and tax-efficient investments in taxable accounts. Doing so allows you to maximize the tax-saving benefits of your tax-advantaged accounts, as well as the after-tax returns in your taxable accounts.”

Ms. Youssef suggested some methods to reduce investment income that counts toward the Medicare surtax:

  • Consider index funds. Index funds have a high potential for tax efficiency. Because index funds don’t trade as much as actively managed funds might, they typically generate less taxable income.
  • Think about adding municipal bonds. Municipal bond interest isn’t included in the surtax calculation. The chance to earn interest that’s excluded from the NII could be a reason to consider using municipal bonds in your portfolio.
  • Invest tax-efficiently. Use tax-advantaged accounts to rebalance your asset allocation or sell holdings that have had significant gains. You may realize better after-tax returns than you would when conducting similar transactions in a taxable account.


Managing your MAGI

When managing your MAGI, Ms. Youssef recommended you consider the following:

  • Roth IRA conversions: Roth IRAs aren’t subject to required minimum distributions (RMDs). Traditional IRAs are subject to RMDs, which will increase your MAGI, despite the IRA and qualified plan distributions being exempt from the NII definition.
  • Distributions from Roth and Roth 401(k) plans: Although qualified retirement plan distributions are exempt from the NII definition, withdrawals from IRAs are part of the MAGI calculations. Roth IRAs and Roth 401(k) plans are excluded from your MAGI if certain rules are met, so distributions won’t count toward the threshold that determines whether you owe the surtax.
  • Qualified charitable distributions (QCDs): When made directly from your IRA to charities that meet the IRS’s definition of a qualified charity, these distributions can count as both an RMD and meet your charitable goals and objectives. These distributions can help you reduce your other income counting as part of your MAGI and potentially decrease your exposure to the Medicare surtax. QCDs were reinstated for 2015 and are now permanent.
  • Loss harvesting: Harvesting capital losses may reduce your portfolio’s taxable capital gains and, as a result, your MAGI.


Keeping perspective on investment income

While no one wants to pay more in taxes than necessary, seeing your investments grow and earn income is a goal of the process. Putting some of the provided suggestions into practice can help you give a smaller slice of those earnings to Uncle Sam—and keep a larger portion for yourself.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

We recommend that you consult a tax or financial advisor about your individual situation.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax (certain exceptions apply, including for Roth conversions).