3.8% Surtax: What You Need To Know

By Jeffery Levine, IRA Technical Expert  
Follow Me on Twitter: @IRAGuru4EdSlott

This week the Ed Slott IRA Discussion Forum featured a question on the recent Health Care Legislation. The new laws will impact IRAs in a number of ways, including a new 3.8% surtax. Curious as to how this new surtax could impact your IRA planning? Read on to find out.

Beginning in 2013, a new surtax on net investment income will affect high income taxpayers whose incomes exceed certain threshold amounts. The threshold for those married filing jointly will be $250,000 and the threshold for single filers will be $200,000. These thresholds are NOT indexed for inflation.

Thankfully, IRA distributions aren’t considered investment income, but that doesn’t mean you can ignore them in your planning process. Why? Because while IRA distributions aren’t considered investment income, they will add to your other income, which could push you towards or over your applicable threshold.

For example, let’s say you are 75 and are single. As a single filer, your applicable threshold would be $200,000. If you normally receive $20,000 of Social Security payments and earn $150,000 of rental income (which is considered net investment income) from some vacation properties you passively rent, you’re a comfortable $30,000 ($200,000 – $170,000 = $30,000) under your threshold. Therefore, even though nearly all your income is investment income, you won’t be affected at all by the 3.8% surtax.

But now let’s say you had a sizable IRA and your required minimum distribution was $60,000. Now, your total income is $230,000 – which is $30,000 over your threshold. Even though your IRA distribution didn’t add any additional investment income, it’s going to cause $30,000 of your existing investment income (your passive rental income) to become subject to the 3.8% surtax…on top of your regular income tax. That’s another $1,140 of tax!

Unfortunately, the law is the law and you can’t change that – unless of course, you happen to be a Congressman. But on the bright side, since the surtax doesn’t take effect until 2013, you can start planning now to reduce your exposure to the surtax later. Such planning strategies might include Roth conversions or the purchase of municipal bonds – both of which will produce tax free income that isn’t subject to the net investment surtax and won’t cause existing investment income to become subject to the surtax.

If you think you may be subject to the new 3.8% surtax on net investment income in 2013, you may want to consider reviewing your situation with a qualified advisor. Be sure to make sure that they have specialized knowledge in this area.

Have more questions? Want to see what other people are asking? Check out the Ed Slott and Company IRA Discussion Forum.