Can You “Burp” Away the Medicare Surtaxes?

November 19, 2013

Burping can relieve more than just stomach discomfort. It can actually relieve the pressure of the new 3.8% Medicare surtax, according to Steve Parrish, a Forbes contributor. His idea of “burping income” is that if a taxpayer can discharge some income at certain levels, it avoids an accelerated build-up of further taxes. This analogy can apply to various triggers in the tax code but is particularly appropriate to the Medicare surtax.

So what is the Medicare surtax?  There are actually two surtaxes – the new 0.9% Medicare surtax and the new 3.8% tax on net investment income. These two provisions were included in the Affordable Care Act, which was enacted in 2010 but didn’t receive much attention until recently because these provisions didn’t take effect until 2013.

Both new taxes are designated as Medicare taxes, with the 0.9% surtax impacting earned income and the 3.8% surtax impacting net investment income.  I will be focusing on strategies to reduce the net investment income surtax by “burping” your MAGI (modified adjusted gross income) since reducing your MAGI can relieve the pressure of the additional 3.8% surtax since it only affects taxpayers who have MAGI in excess of certain threshold amounts: $250,000 in the case of married taxpayers filing a joint return or a surviving spouse, $125,000 in the case of a married taxpayer filing separately, and $200,000 for single filers.  Any net investment income over these thresholds would be subject to an additional 3.8% tax on top of the typical 15% capital gains rate (now increased to 20% for those in the 39.6% ordinary income tax bracket).

Mr. Parrish provides the following example to illustrate the tax:  “Let’s say the married couple has a total of $300,000 MAGI and $75,000 NII. Only $50,000 of their $75,000 NII will be subject to the tax, because that is the amount which exceeds the $250,000 MAGI threshold. They would have a Medicare Surtax of $1,900 ($50,000 times 3.8%).”

To relieve the pressure of this tax, the couple could “burp” either their ordinary income or their net investment income to reduce or avoid the 3.8% surtax. Since there are a few paychecks left before year-end, both spouses should make sure they are on track to max out their 401(k) plans and should also check with their employers to determine if there is a non-qualified deferred compensation plan available to reduce their income. To reduce net investment income,  the couple could consider investing in municipal bonds or a tax-deferred annuity or even gift some of their appreciated assets instead of selling those assets since that would cause them to realize a capital gain that could throw their net investment income over the threshold.

This surtax is going to be a surprise to many taxpayers. If you are expecting to have significant net investment income this year, talk to your tax advisor. You may be able to “burp” away this unpleasant new surtax.