The Medicare Surtax was the key fundraiser under Obamacare – the new health law. It represents a massive overhaul of America’s health insurance and delivery systems, and includes more than $400 billion in new taxes. The taxes are imposed on employers and on individuals. It becomes effective in 2013, so there is still time to do some planning before 2012 ends.
One of the most controversial aspects of the law is the 3.8% surtax on net investment income. Net investment income must be distinguished from “earned” income. Investment income includes interest, dividends, capital gains, annuities, royalties and passive rents.
Net investment income does not include distributions from qualified retirement plans (e.g., an employer-sponsored defined benefit plan, profit sharing plan, money purchase plan, Employee Stock Ownership Plan, a so-called 401(k), 403(b) or 457(b) plan). The term does not encompass distributions from an IRA or tax-exempt municipal bond – so, distributions from one’s Roth or regular IRA, for example, will not be hit with the surcharge. These exemptions from the surcharge make good economic sense. Congress does not want to discourage taxpayer’s from investing in their own retirement planning since the Social Security scheme is in obvious turmoil. It also does not want to discourage taxpayers from investing in municipal bonds, since these debt obligations which are issued by states, cities, counties and other governmental entities, use the money for projects such as building schools, roadways, and other projects for the public welfare.
If the individual is single, the surtax will apply if the taxpayer has a modified adjusted gross income (“MAGI”) exceeding $200,000, but if married and filing jointly, the surtax will apply if this number exceeds the paltry sum of $250,000 per couple. This provision is a penalty for getting married – somehow Congress seems to prefer that taxpayers live in sin. If it didn’t, then each individual in the marriage would be treated as two separate taxpayers and the threshold would be reached at $400,000 for married couples.
In Determining Applicability of the Surcharge and Calculating the Tax — Add Back Foreign Earned Income
The 3.8% surtax is imposed on the lower of the taxpayer’s net investment income or the excess of MAGI over the income thresholds. For Americans residing overseas, MAGI is the regular Adjusted Gross Income plus all foreign earned income. Therefore, in determining if the surcharge will apply, and in calculating the 3.8% surtax, do not forget to add back any “Foreign Earned Income” or “Foreign Housing” exclusion amounts.
Nice Break for Nonresident Alien Individuals
It should be noted that nonresident alien individuals are specifically exempt from the 3.8% surcharge. This is important, for example, for the nonresident alien owning investments or properties in the US and earning passive rents, dividends or capital gains with respect to the properties.
A Not-So-Nice Break for Those Planning to Expatriate
Another way the surcharge can sting in the international context involves those planning on expatriating after December 31, 2012 (that is, giving up US citizenship or relinquishing a”long term” green card). If the individual will qualify as a so-called ‘covered expatriate’, the person will be hit with the Exit Tax. Essentially, this means that the ‘covered expatriate’ will be treated as selling all of his worldwide assets the day before the expatriation date and will be required to pay an “exit tax” on the phantom gain from such deemed sale. In many cases, the gain may qualify for tax at beneficial long-term capital gain rates (currently at 15%; but likely go up to 20% as of January 1 2013). The double-whammy lies in the surcharge – the 3.8% surcharge will also apparently apply to such deemed gains if the MAGI thresholds are met. The Exit Tax must be computed via one’s Form 1040 with the gain or loss being reported on the relevant part of the 1040 for the part of the year that the taxpayer is still considered a US person.
Selling appreciated assets in 2012 instead of 2013 can help taxpayers dodge the surtax. This would apply to sales of appreciated stocks, for example. Many taxpayers have concerns about selling their principal residence in 2012 instead of 2013 to avoid application of the 3.8% surtax. It should be noted that due to application of special exclusion rules for gain on the sale of a principal residence, only the gain exceeding $500,000 for married taxpayers ($250,000 for single) could be hit with the 3.8% surtax assuming the taxpayer’s AGI is over the base thresholds, mentioned previously. If gain on the sale of the home can be sheltered under the exclusion rule, it will not matter if the home is sold in 2012 or later. Bear in mind that the exclusion rule only applies to gains on the sale of one’s principal residence and not on vacation homes or rental properties. One should consider selling these properties in 2012 to avoid the surtax.
If the individual will qualify as a “covered expatriate’ the expatriation should be done before year-end!