New 3.8 Percent Surtax Applies To Investment Income Above The Threshold

Normally the phrase "historic first" is reserved for some admirable and useful advancement of human achievement. However, if you are among America's top earners, it is now applicable in a substantially less glamorous context.

The very first surtax on capital gains and dividend income is already in effect. If you have a relatively high income, you could benefit from a little more information on this new tax and may even wish to explore tax planning options to lower your tax liability.

Single filers with investment and earned income over $200,000 taxed

The 3.8 percent investment income surtax went into effect in 2013. Passed in 2010 as part of the Health Care and Reconciliation Act, the tax is meant to account for some of the health care costs associated with the Patient Protections and Affordable Care Act.

This new surtax is unique in many ways, and only applies to taxpayers who meet the criteria. First off, the tax is only applied to what the IRS considers "unearned" investment income - gains acquired through stocks, bonds, mutual funds, loans and the like. Second, the tax only applies to those who have a modified adjusted gross income that exceeds $200,000 ($250,000 for married couples filing jointly).

Although it is somewhat of a simplification, for most purposes, adjusted gross income can be thought of as all income from taxable sources with allowable deductions (qualifying retirement plan contributions, unreimbursed business expenses, alimony, medical expenses, etc.) subtracted. The "modified" portion comes in when certain items are added back in to the calculation of taxable income.

Example scenario

As an example, imagine a single filer who in a given year made $170,000 in wages and received an additional $80,000 in dividends from a passive stock investment, to put her modified adjusted gross income at $250,000. Since this amount exceeds the $200,000 threshold for a single filer, some of her investment income will be subject to the 3.8 percent surtax.

The 3.8 percent surtax applies to the lesser of the taxpayer's net investment income or the amount of modified adjusted gross income above the $200,000 threshold. In this case, $80,000 is the taxpayer's net investment income, and her modified adjusted gross income minus $200,000 is $50,000, so her surtax would be 3.8 percent of $50,000 ($1900). This is only a simplified example, of course, and in real life, a taxpayer at this level of income would have to navigate a convoluted web of other taxes, deductions, exceptions and regulations.

If it seems complicated, it is. The rollout of the new investment income surtax came with a 159 page rulebook, which, sad to say, is a sterling example of what the IRS considers brevity.

Making legal arrangements in advance can lower your tax bill

The 3.8 percent investment income surtax applies not only to earners at the top of the income scale, but also applies to certain estates and trusts. While 3.8 percent might not seem like all that much, it can quickly add up to thousands wherever a particularly heavy portfolio is concerned.

If you wait until the tax is already due, it can be too late to do much about a sizeable tax bill. On the other hand, careful tax planning and estate planning undertaken well in advance could substantially lower your tax liability. If the new 3.8 percent surtax might affect your investment income, get in touch with a tax planning attorney today; your lawyer could prevent you from losing thousands to the IRS.