New Tax on Investment Income

By Lori Shrout, EA, Manager at Gumbiner Savett Inc.: Investors and property owners should be aware of the new Medicare tax on investment income.

Investors and property owners should be aware of the new Medicare tax on investment income.  IRC Code Section 1411, enacted under the Patient Protection and Affordable Care Act, introduces a new 3.8 percent Medicare tax on net investment income starting in 2013. The tax would apply to individuals with annual income in excess of $200,000 (single) or $250,000 (married couples). It will also apply to some estates and trusts with undistributed net investment income.

What is investment income? Investment income includes net taxable income from interest, dividends, royalties and annuities. Net rental income will be considered investment income if your rental is a passive activity under the existing passive loss rules of IRC Code Section 469. Now may be the time to revisit these rules to see if your rental could be considered an active trade or business.

Net capital gains are investment income. Also included is income from any business in which you do not materially participate (such as investment partnerships).

Retirement income is specifically excluded from the definition of investment income under this code section, so it will not be subject to the additional tax. Taxable retirement distributions would, however, be included in your gross income for determining if you are over the $200,000 or $250,000 threshold. This may make Roth-type plans, where the distributions are non-taxable, even more attractive.

This new tax on investment income comes at the same time we are looking at the expiration of the 2001 and 2003 Bush-era tax cuts. The maximum capital gain rate is set to increase from 15 to 20 percent in 2013. Add to this the additional 3.8 percent Medicare tax on investment income, and your capital gains will cost you 8.8 percent more in 2013 versus 2012.

Medicare tax on earned income will also increase. Currently, employees have 1.45 percent withheld from all wages, regardless of the amount.  Employers match this, for a total of 2.9 percent paid into Medicare. Self-employed individuals pay the full 2.9 percent. Starting on Jan. 1, 2013, Code Section 1411 will add another 0.9 percent on any earned income amounts over $200,000 for single taxpayers or $250,000 for married couples. This additional amount is all paid by the employee or self-employed individual, with no employer portion. Employers will be required to withhold the additional Medicare tax on wages or compensation paid to an employee in excess of $200,000 in a calendar year.

The IRS has recently issued a set of FAQs for the additional Medicare tax in an attempt to give guidance to employers and payroll service providers while they implement these new withholding rules.