What is considered investment income?
The health care laws implement a 3.8% surtax on net investment income starting in 2013. Below is a list of what is and is not considered investment income.
Investment Income: Interest, dividends, capital gains (long and short), annuities (not those in IRAs or company plans), royalty income, passive rental income, other passive activity income.
NOT Investment Income: Wages and self-employment income, active trade/business income, distributions from IRAs, Roth IRAs and company plans, excluded gain from sale of a principal residence, municipal bond interest, proceeds of life insurance policies, veterans? benefits, Social Security benefits, gains on sale of an active interest in a partnership or S corporation © 2013 Ed Slott and Company, LLC
Step 1. Identify the surtax income thresholds.
The first step is to know the MAGI (modified adjusted gross income) thresholds to avoid the 3.8% surtax on net investment income. They are as follows: Married Filing Jointly ($250,000); Individuals ($200,000); Married Filing Separately ($125,000); Trusts and Estates (approximately $12,000). Trusts and estates are hit particularly hard with the surtax kicking in at a much lower income level.
Step 2. Look at TAXABLE income.
Taxable income from all sources can push taxpayers over the MAGI threshold and cause their investment income to be subject to the 3.8% surtax. Income tax-free Roth distributions will NOT affect MAGI.
Step 3. Understand how much will be taxed.
The 3.8% surtax is imposed on the lesser of (1) net investment income or (2) the amount of MAGI over the certain income threshold. Taxpayers with income below those MAGI levels will NOT be subject to this tax.
Step 4. Know other health care tax provisions coming in 2013.
The 3.8% surtax gets the attention, but there is also an additional 0.9% Medicare tax on wages and self-employment income over the MAGI thresholds. Also, medical expenses must exceed 10% of AGI (up from 7.5%) to be deductible (if age 65 or older, this provision is effective in 2017). That 10% also applies to the medical expense exception to the 10% penalty on early IRA or plan withdrawals.
Step 5. Discuss these tax planning points.
You need to know that while IRA and plan distributions are exempt from the surtax, taxable distributions from these accounts can push income over MAGI thresholds. Roth conversions can be a valuable tool to eliminate future taxable income, especially for taxpayers with significant investment income or a discretionary trust as their IRA beneficiary. Conversions could push you above your thresholds in the short-term though. Salary deferrals (401(k)s for example) can reduce MAGI for the 3.8% surtax but NOT for the 0.9% additional Medicare tax.