Avoiding the 3.8% Surtax

Today, I hosted an excellent Advisor's Forum teleconference on avoiding the 3.8% surtax presented by Bob Keebler, CPA.  The surtax kicks in in 2013, and is an additional 3.8% tax on certain high income earners.  The tests for whether or not a person will incur the tax are rather complex, but not terribly complicated.

Will you be subject to the Surtax?

First, you must meet the income threshold before the tax is incurred, the Surtax Threshold.  The thresholds are $200,000 for inviduals, $250,000 for married couples, $125,000 for married filing separately, and $11,200 for trusts and estates.  The threshold is met if your Modified Adjusted Gross Income (MAGI) exceeds the proscribed levels.  For most taxpayers, the MAGI will be the same as Adjusted Gross Income, which is gross taxable income less above the line deductions.


If your income (MAGI) exceeds the threshold in 2013 and later, then you might owe the tax.  The next test is you must have Net Investment Income.  Net Investment Income is essentially taxable investment income less costs incurred to generate that income.  If you have net investment income, then the 3.8% Surtax will apply to the lesser of your Net Investment Income or the excess of your MAGI over the threshold amount.

Examples:

1. Alice, a single person with $500,000 of wages income, with no investment income, will not be subject to the Surtax.
   
2. Bob, a single person with $400,000 of wages income and $100,000 of net investment income, will owe the 3.8% Surtax on the entire $100,000 of his net investment income.
3. Cathy, a single person with $100,000 of wages income and $400,000 of net investment income, will owe the 3.8% Surtax on $300,000 of her net investment income.

Notice the total income in all three examples is the same, but Alice pays $0 Surtax, Bob pays $3,800 of Surtax, and Cathy pays $11,400 in Surtax.  Cathy did not owe Surtax on ALL of her net investment income because the Surtax is limited to the lesser of her Net Investment Income ($400,000) and the excess of her MAGI ($500,000) over the Surtax Threshold ($200,000).   $500,000 - $200,000 = $300,000 subject to the Surtax.


Ways to avoid the Surtax


The simplest ways to avoid the Surtax is to avoid taxable investment income.  Without it, there can be no Surtax imposed.  This means investing in Muni Bonds, Life Insurance, Annuities, IRAs. 


If you will have taxable investment income, you can minimize your tax by minimizing your MAGI.  Traditional IRA distributions will increase your MAGI, but Roth IRA distributions will not.  This makes a strong case for many taxpayers to convert their IRAs to Roth in 2010, 2011, and/or 2012.

Why does this tax exist?

I really do not get this tax.  I am not sure how much thought goes into tax legislation.  The claim is this tax is designed to help pay for the Health Care Bill.  While that may be the justification of the tax, I am very skeptical it will meet that goal, and consequently, I am just not sure if that is its purpose.  Because tax legislation is more driven by politics than logic, it is often unclear whether the behaviors of Americans that are driven by tax laws are by design or by accident.  Impact studies seem to assume that taxpayers will not modify their behaviors, and if they do not, the study provides a decent look into what the tax cost or revenue to the goverment is.  Of course, taxpayers do change their behavior based on the tax laws.  So I see its justification as a means to increase revenue to pay for the Health Care Bill as suspect. 


This tax is fairly easy to avoid, which makes it look more like social engineering than a revenue producer.  This tax clearly favors wage earners over investers.  If it disfavors investing, does that make the tax designed to promote spending over investing?  Money spent doesn't generate future investment income, and therefore avoids the Surtax.  The Surtax further favors tax-free investments over taxable investments, so maybe it is designed to encourage taxpayers to lend money to the government.  It encourages investing through life insurance for tax-free investing and annuities for tax deferred investing.  It favors growth investing over investing for dividends, as there is no Surtax on unrecognized gains.  It encourages investing in oil & gas.