The Net Investment Income Tax (also called the Medicare Surtax) often takes people by surprise when it's time to pay Uncle Sam. This little-known tax can be properly handled with careful tax planning in advance, which can help mitigate and even eliminate the surtax for many taxpayers.
While most financial advisors and CFPs don't offer too many solutions on how not to get slammed by this potentially costly tax, your trusted financial advisors in Greenville, SC, at Global View are here to provide our clients with the necessary tax-planning solutions. Many advisors don't provide tax planning. Truth be told, many frankly are not allowed to list it in their advisory services. Though that is a shame, in this article, we will provide the following insights:
- What is the Net Investment Income Tax?
- The potential impact of the Medicare surtax on you
- As a high-earning individual, how can I minimize the impact of the Medicare surtax?
- Is it necessary to pay both taxes?
- What investment strategy can I implement to decrease my tax liability?
As a high-earning individual, proactive and diligent tax-planning strategies will be one of your most important financial decisions. A sound tax planning strategy is imperative for healthy financial planning and wealth management, especially for more affluent clientele.
What is the Net Investment Income Tax?
You may owe an additional 3.8% in taxes, called the Net Investment Income Tax, or NIIT (also called the Medicare Tax). However, you will only owe this tax if both your investment income and modified adjusted gross income, or MAGI, exceed a specific set amount.
What counts towards your net investment income are short and long-term capital gains, all dividends, any rental income, and any passive investment income. Any wages, Social Security, or income from retirement plans does not count towards your net investment income.
The IRS uses the following criteria to determine whether or not your MAGI exceeds the threshold:
- $200,000 for single individuals
- $250,000 for married individuals filing jointly
- $125,000 for married individuals filing separately
Should your investment income exceed the MAGI threshold, you will be slapped with a 3.8% tax towards your net investment income or the amount that exceeds your MAGI threshold, whichever is less.
How Does the Medicare Surtax Affect me?
How the Medicare surtax affects you will depend on your MAGI and your corresponding capital gains tax rate. Depending on your filing status and income, you will fall into one of three brackets which will be taxed at either 0%, 15%, or 20%.
So, in theory, the Medicare surtax may apply to anyone from the upper middle bracket (15%) to those in the highest capital gains tax bracket.
For example, a married couple that earns $325,000 in income would not qualify for the 20% bracket. However, a portion of their investment gain would be subject to a rate of 18.8% (15% plus the 3.8% Medicare surtax) since they surpassed the NIT threshold of $250,000. Suppose this same fictitious couple saw their income take a fortuitous leap to $550,000, a part of their investment gains would subsequently be taxed at 23.8% (20% capital gains tax, plus the 3.8% surtax).
How Higher Income Earners can Reduce the Surtax
I wish all of my clients such profits and financial good fortune in 2023 that they simply could not avoid the Medicare surtax no matter how hard they tried. However, that is, unfortunately, an unlikely occurrence, but I have plenty of advice for everyone to help mollify the effect of the Medicare surtax.
Always be mindful of how you can reduce your adjusted gross income. The lower it is, the lower the amount eligible for the 3.8% surtax will be. Keep this in mind when you are making retirement contributions.
For example, contributions towards a 401(k) will lower that number and should be something you keep in mind while considering investment management strategy. Any charitable contributions from an IRA, if you are 70 1/2 or older, will also lower your adjusted gross income.
Tax-loss harvesting is also an excellent strategy to use. Many advisor services don't include this strategy in their management services, and it is vastly underutilized. The surtax only applies to your net investment income, so if you are making significant gains with one holding, there may be losses on other holdings that can help minimize your overall net capital gains.
This strategy can be difficult to explain broadly, although it is a great way to reduce the surtax according to your own personal financial situation. One of our financial advisors in Columbia, SC, would be happy to lend a hand in determining the best tax-loss harvesting solutions for you.
If you plan to sell your home, consider a few important points and how they relate to the Medicare surtax. Most people will not owe any capital gains tax the year they sell their primary residence since you can exclude up to $500,000 for married individuals ($250,000 for single) in profit from the sale of the home. If you have exhausted other strategies or they simply will not work for you, this can be a viable option to consider if you have been planning or contemplating selling your home.
Tax Planning is a Priority for High-Income Individuals
Most financial advisors and certified financial planners will not offer tax planning services. If they do, it may be unlikely that it's up to the standard you need. Higher-income, affluent individuals and families are not the everyday clients of most advisors, although that does not take away from the fact that they still need an airtight tax plan.
Estate planning and investment management are vital parts of your overall financial plan, but without sound tax planning strategies, you will continue to pay much more than you need to year after year. A 3.8% surtax may not sound like much, but it is something many have not heard of, and when you add up the years it has been levied against you, unbeknownst and unprepared, the total amount is likely more than you would imagine.