Robert A. Green
Registered: Nov 2007
09-05-12 06:58 PM
High-income traders are hit with ObamaCare’s 3.8% Medicare tax on investment income
September 5, 2012
Other advisers who suggest traders might be able to avoid the new Medicare tax on unearned income with an S-Corp are wrong. This primer for traders and investment managers offers planning tips surrounding the new Medicare taxes.
By Robert A. Green, CPA
The Patient Protection and Affordable Care Act (ObamaCare) makes a big political point of raising taxes on the rich — defined as individuals with adjusted gross income (AGI) exceeding $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately) — and on the investor class, too. On Jan. 1, the first revenue raisers — the Medicare tax hikes on earned and unearned income — kick in. (The more contentious health-insurance mandate or tax penalties don’t start until 2014.)
The current Medicare tax rate of 2.9 percent applies to all earned income. But if you’re in one of the previously stated income groups, a new 0.9 percent Medicare hospital insurance tax raises this rate to 3.8 percent.
The more significant ObamaCare tax issue is this: Starting in 2013, the 3.8-percent Medicare tax will be applied to unearned income, too, for individuals exceeding these income thresholds. (Technically, it’s modified AGI, which means U.S. residents abroad must add back any foreign earned income exclusion reported on Form 2555.)
Unearned income includes investment or portfolio income (interest, dividends, most capital gains, and annuities), royalties, rents, and passive activity income, as well as gains from the sale of property not used in an active business.
The 3.8-percent Medicare tax on unearned income doesn’t apply to qualified plan distributions (retirement plans) or income from the disposition of, or pass-through from, active (earned-income related) LLCs, partnerships, and S-corps, among other revenue sources. But it does apply to taxable income of trusts with undistributed net income in excess of the dollar amount at which the highest tax bracket for trusts begins (this amount is $11,650 in 2012).
While the Medicare tax on earned income is 50-percent tax deductible, it is not deductible on unearned income. Employers pay half the 2012 Medicare tax and withhold the other half from employees’ paychecks. Investors have to pay the tax on unearned income through estimated taxes and with their tax balance due.
Planning tips: Selling profitable investment positions before year-end 2012 and accelerating other unearned income could be a wise tax move if you know you are going to be over the $200,000/$250,000 income threshold in 2013, triggering the Medicare tax. Plus, if Bush-era tax cuts expire, ordinary, qualifying dividend, and capital gains tax rates will rise in 2013, too.
As is the case with self-employment tax calculations, the Medicare tax on unearned income is assessed on net investment income. That’s defined as net trading gains — proceeds minus cost basis on securities — less “properly allocable” expenses. For traders and investors, these allowable expenses include trading expenses. For business traders, all trading expenses are deducted on Schedule C or on a pass-through entity tax return. For investors lacking trader tax status, Section 212 investment expenses don’t include education, home office, and some other expenses.
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A version of this article appears in Active Trader’s November issue, on newsstands in October.