Beyond Bulls & Bears

Wealth Planning

Planning moves to lessen the sting of the 3.8% surtax

A rising number of US taxpayers are subject to an investment income surtax, introduced a decade ago in federal legislation. Here are some strategies that may help mitigate the impact of the tax.

Since 2013, many higher-income US taxpayers have had to pay a 3.8% surtax on net investment income. Part of the landmark Affordable Care Act signed into law in 2010, this provision was designed to raise revenue to offset other costs including tax credits for consumers purchasing health insurance on the exchanges.

We believe it’s important to understand how this tax applies in order for taxpayers to better manage their tax bill.

Who is subject to the surtax?

Single taxpayers whose modified adjusted gross income (MAGI) exceeds $200,000 are potentially subject to the surtax. For married couples filing a joint return the threshold is $250,000. (For married couples filing separately, the MAGI threshold is $125,000). Interestingly, unlike most provisions in the tax code, these thresholds are NOT adjusted for inflation each year which means that more taxpayers are subject to the tax each year. In fact, since its inception the number of individuals subject to the tax has doubled.

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What type of income is subject to the surtax?

The surtax is applied broadly to most non-wage income including interest, dividends, capital gains, royalties and certain rents. Importantly, it does not apply to pension or retirement income, including distributions from retirement accounts and IRAs, or Roth conversions. Other types of income that are not subject to the surtax include:

  • Social Security benefits
  • Tax-free municipal bond income
  • Net unrealized appreciation portion on the distribution of company stock from a qualified retirement plan

It’s important to note that while the 3.8% surtax doesn’t apply to retirement income, an IRA distribution or a Roth IRA conversion may result in additional taxable income and cause a taxpayer to exceed the MAGI thresholds ($200,000 for individuals, $250,000 for married couples filing a joint return), exposing other income sources such as dividends or capital gains to the surtax.

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Is business income subject to the surtax?

Certain income generated from pass-through businesses is also subject to the surtax. This would include income sources from passive business activity (rental real estate income, for ex.). Passive activities include trade or business activities in which you don’t materially participate. Generally, income derived from a business where the taxpayer is actively participating is not subject to the surtax. You materially participate in an activity if you’re involved in the operation of the activity on a regular, continuous, and substantial basis. For more information, see IRS Publication 925, Passive Activity and At-Risk Rules.

Considerations for mitigating the impact of the 3.8% surtax

  • Reduce or defer taxable income. Contributions to tax-deferred retirement plans, IRAs, or health savings accounts (HSAs) may enable a taxpayer to avoid exceeding the income thresholds for the surtax. Another way to reduce taxable income is by claiming an itemized deduction, for example charitable contributions. Additionally, there may be ways to defer current income through a deferred compensation arrangement or an installment sale of property, for example.
  • Manage income to avoid exceeding the MAGI thresholds. For example, if earning investment income in a taxable account (capital gains, dividends, etc.) and considering a Roth IRA conversion, make sure the amount of the conversion does not result in MAGI exceeding the $200,000 or $250,000 threshold depending on filing status. Exceeding those MAGI thresholds will trigger the additional 3.8% surtax.
  • Utilize Qualified Charitable Distributions (QCDs) for annual donations. Requesting a QCD from an IRA can satisfy a required annual distribution. By avoiding income from an RMD, the taxpayer may be able to avoid crossing the income threshold where the 3.8% surtax applies to other income such as interest, capital gains and dividends. See “Donating IRA assets to a charity.
  • Consider investing in municipal bonds. Depending on the investor’s circumstances, tax-free income from municipal bonds may help avoid the impact of the surtax. Of course, investors need to carefully weigh the merits from an investment perspective first before considering the tax benefits.
  • Reclassify passive business income to active business income if possible. There are steps a business owner may take to avoid income generated from an entity as being defined as passive income. For example, the owner may be able to take an active role to materially participate in the business according to IRS rules. Business owners should consult with a qualified tax professional since these types of IRS requirements can be fairly complex.


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