3 Rules You Must Know About the 3.8% Surtax | Ed Slott and Company, LLC

3 Rules You Must Know About the 3.8% Surtax

By Jeffrey Levine, IRA Techical Expert
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@IRAGuru4EdSlott

In 2010, as part of the Healthcare Acts (more commonly known as Obamacare), Congress authorized a new 3.8% surtax on net investment income. The tax, which first took effect in 2013, is assessed on net investment income above an applicable threshold. The thresholds are as follows:

Single Filers - $200,000
Married – Joint - $250,000
Married – Separate - $125,000

Note: These thresholds are not indexed for inflation.

The rules governing the 3.8% surtax are incredibly complicated, and it is unlikely that you will ever need to know more than a handful of them. If you have an IRA or other retirement account, that handful of rules likely includes one or more of the three discussed below:

  1. Distributions from retirement accounts are not “investment income”

IRAs, 401(k)s and other retirement accounts can hold a wide variety of investments, but regardless of what you choose to buy and/or sell within your retirement account, when you ultimately take a withdrawal from that account, the distribution will not be considered investment income. As a result, the distribution from your retirement account will not be assessed the 3.8% surtax.

If you think about it conceptually, this actually makes a lot of sense. Take a 401(k) for instance; when you contribute money to a 401(k) plan via a salary deferral, you reduce your wages. Wages, of course, are clearly not investment income. Instead, wages are earned income (which can be subject to a separate, 0.9% surtax). So if the money going into your 401(k) wasn’t investment income to begin with, it certainly would not make sense for it to be treated like investment income upon distribution... and it is not.

  1. Distributions from retirement accounts can increase your overall income

Just because retirement account distributions are not subject to the 3.8% surtax does not mean you can ignore them in your planning, at least not if you want to minimize your exposure to the tax. That is because when you take a distribution from your IRA or other retirement account, it can increase your overall income and make other investment income that was not previously exposed to the surtax subject to its impact.

For example, let’s say you are married and you and your spouse collectively have modified adjusted gross income of $250,000. $30,000 of that income consists of dividends, interest and capital gains, all of which are considered investment income. Here though, because your total income does not exceed your applicable threshold of $250,000, you do not owe any 3.8% surtax.

Suppose, however, that in addition to the income described above, you decide that you want to convert $50,000 from your IRA to a Roth IRA. Now your total income is $300,000, which is $50,000 over your threshold. As a result, your $30,000 of previously non-3.8%-surtaxed investment income will now be subject to the surtax. That’s an additional $1,140 of tax – on top of “regular” income tax – that can be entirely attributed to your Roth IRA conversion, even though that income technically wasn’t subject to the tax.

Ultimately, it is just a matter of semantics. Who really cares what income the tax is technically assessed on? All that really matters is that your bill to Uncle Sam is higher.

  1. NUA is not considered investment income

In general, capital gain income is considered investment income. There are a few exceptions to this general rule, though, one of which is for NUA. NUA, or net unrealized appreciation, is a special tax break for appreciated employer stock held inside a qualified plan. In essence, NUA allows you to swap the ordinary income tax treatment you normally get on retirement account distributions for more favorable long-term capital gain treatment.

When a valid NUA transaction is made, appreciated shares of employer stock held inside a qualified plan are moved, in kind, to a taxable account, such as an individual brokerage account. From there, the shares can be sold, which triggers long-term capital gains tax on the growth of the shares that occurred while they were still in the qualified plan. This combination of facts can be confusing, even for experienced CPAs. On one hand, the NUA can be traced back to a retirement account, and we already know distributions from retirement accounts are not investment income and therefore, are not subject to the 3.8% surtax. On the other hand, the gain is considered a capital gain, which is typically considered investment income and therefore, potentially subject to the surtax.

Thankfully, IRS has made their position on this issue very clear. In final regulations that cover the 3.8% surtax, the IRS expressly excluded NUA from investment income.

A final word of warning on this topic: if you sell NUA shares in your taxable account, make sure your CPA or tax preparer knows that the shares you have sold came from an NUA transaction. If you fail to do so, the overwhelming likelihood is that your tax preparer will just assume the gain is from a “regular” capital gain. That could very easily lead to you paying the 3.8% surtax on income that should not be subject to the tax.

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