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The start of the new calendar year, 2013, marks an important turning point for taxpayers. As taxpayers begin preparing their tax returns for April 15, they must take into consideration several new tax rates that come into effect this year. One new piece of tax legislation of particular interest that will be the focus of this and the next several posts is the new 3.8% net investment income tax.

In 2010, as part of the health care legislation often referred to as ‘Obamacare’, Congress passed a new tax provision, the Unearned Income Medicare Contribution. This levy, which places a 3.8% tax on various forms of investment income for individuals, trusts, and estates, has been referred to by a number of names. Some of these include the ‘3.8% Medicare Contribution tax’, the ‘3.8% tax’, the ‘3.8% investment tax’, and the ‘3.8% Medicare tax’. Despite these names, it is interesting to note that contributions are not actually designated for the Medicare Trust fund. For the purpose of this post and the posts that will follow, this new tax will be referred to as the ‘3.8% Medicare Surtax’.

Before focusing on the specific application of the 3.8% Medicare Surtax to an individual investment situation, it is important to establish a general understanding of this tax. The 3.8% Medicare Surtax is outlined in IRC Sec. 1411 under Chapter 2A. In addition to Code Sec. 1411, this past December the IRS also released proposed regulations to aid and guide taxpayers affected by this new tax. This hundred-plus page document, which includes a preamble and 11 sections, will be subject to revisions and open to comments throughout this year. The IRS hopes that final regulations will be released at the end of this year, but in the meantime taxpayers can rely on the proposed regulations when determining their own 3.8% Medicare Surtax for 2013.

There are four parts to Code Sec. 1411:

1. Calculation of 3.8% Medicare Surtax for individuals
2. Calculation of 3.8% Medicare Surtax for trusts and estates
3. General definition of terms
4. Special exceptions and situations

For individuals, the calculation of the 3.8% Medicare Surtax is dependent on two components: a taxpayer’s net investment income (‘NII’) and his or her modified adjusted gross income (‘MAGI’). For each taxable year, the MAGI, after being reduced by a fixed threshold, is compared to NII. The 3.8% Medicare Surtax is applied on the lesser of the two. This means that for individuals who have little or no net investment income, their 3.8% Medicare Surtax will be minimal if not zero. The three thresholds mentioned above are:

1. $250,000 for married couples filing jointly
2. $125,000 for married couples filing separately
3. $200,000 for everyone else

To illustrate the effects of this tax on an individual, take the following example. John Adams, who is single, made $150,000 in salary for 2013. In addition, John Adams also collected $75,000 of net investment income. John’s modified adjusted gross income would be the sum of his salary and net investment income this year, or $225,000. Since he is not married, his threshold is $200,000, which means is MAGI after being reduced by a fixed threshold is $225,000 – $200,000 or $25,000. When compared to his $75,000 of NII, the 3.8% Medicare Surtax is applied to the $25,000. Therefore, for 2013, John’s taxes increase by $25,000 x 0.038 or $950 after taking into effect this new 3.8% Medicare Surtax.

For estates and trusts, the calculation of the 3.8% Medicare Surtax is also dependent on two components: an estate or trust’s undistributed net investment income (‘UNII’) and its adjusted gross income (‘AGI’). Similar to the calculation for individuals, the AGI for the taxable year is first reduced by a fixed threshold amount, and then compared to UNII. The lesser of the two is multiplied by 3.8% to determine the 3.8% Medicare Surtax for that taxable year. Unlike the calculation for individuals, however, the threshold is adjusted each year based on the dollar amount that starts the highest tax bracket. For the fiscal year of 2013, that amount is $11,950.

Although it is uncertain to what extent this new tax will have an impact on taxpayers in the US, it is clear it will be substantial. Please stay tuned as we explore the key elements that compose the 3.8% Medicare Surtax such as the critical net investment income calculation, comments and suggestions that noted tax professionals have raised, and exactly how this new tax will affect you and your checkbook.

To learn more about Code Sec. 1411 and access the IRC section, click here .

By Lewis J. Saret, with assistance from Jenny Ong