During 2010, Congress approved and the President signed the Health Care and Education Reconciliation Act (P.L. 111-152).  With the recent U.S. Supreme Court decision clarifying the constitutionality of certain provisions of this legislation, we now know that the 3.8 percent Unearned Income Medicare Contribution Tax (UIMCT) will apply beginning January 1, 2013. The new tax applies to certain passive investment income of individuals, trust, and estates.  This article will focus on the individual tax effects of the UIMCT.

As is common with tax legislation, we get some new acronyms to define and understand:

  • NII:  Net Investment Income
  • MAGI:  Modified Adjusted Gross Income
  • ATA:  Applicable Threshold Amount

First let’s define these three new acronyms; starting with the easiest and working our way to the more complex.

ATA = refers to amounts of MAGI and is different depending on your filing status:

  • Married, filing jointly              $          250,000
  • Married, filing separately                    125,000
  • All other individual taxpayers
  • (single or head of household)           200,000

MAGI = Generally refers to line 39 of Form 1040, but could be modified (increased) by net foreign-source income.  This modification will be very rare.

NII = This is clearly the complex element of this new tax.  If your MAGI exceeds your ATA then you will need to understand NII.  The UIMCT of 3.8 percent is applied to the lesser of your NII or your excess of MAGI over your ATA.  I know it is alphabet soup but read it slowly, it will make sense.

There are three categories of income that comprise NII:

  • Interest, dividends, annuities, royalties, rents, and these may all be reduced by deductions attributable to these sources.
  • Passive activity trade or business income net of normal deductions.
  • Net gain from the sale of property other than property held in an active business.

The planning strategies to reduce MAGI or NII will lead you to review your investment assets and consider alternatives such as:

  • Tax-exempt bonds
  • Tax-deferred annuities
  • Life insurance
  • Oil and gas investments

The timing of certain investment related transactions will also be important in the management of NII and MAGI in relation to your ATA.  Examples of transactions that require professional planning:

  • Establishing a charitable remainder trust
  • Selling an investment asset on installment
  • Converting and IRA to a Roth IRA
  • Receiving distributions from a trust or estate.

Also, for years we have focused on maximizing above-the-line deductions because “the line” (Adjusted Gross Income) has been the base used for upwards of two dozen phase out provisions.  Now, once again “the line” is the focal point for applying a special tax rate add-on of 3.8 percent.

As we close out 2012, consider the timing of income between 2012 and 2013 given possible higher rates in 2013, consider the value of deductions in each year also given the higher rates likely in 2013, know your ATA for 2013, and estimate your NII and MAGI.  Now is a good time to contact your tax professional and investment advisor to have a joint planning session to position yourself in 2012 for what’s coming in 2013.