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What the Medicare investment tax means for you

February 27, 2014

An important tax change from the 2010 federal health care law is now in effect for investors filing their 2013 federal returns.

Here's a general overview of what the change may mean for you. The rules are fairly complex, and you may want to consult a professional tax advisor for guidance. If you have questions about how your Vanguard investments are affected, call us at 877-662-7447. However, please be aware that our associates can't provide specific tax advice.

The Medicare surtax in a nutshell

As a result of the Affordable Care Act of 2010, a new 3.8% investment "surtax" to fund Medicare expansion is now in effect and is reportable on IRS Form 8960 PDF. Here's who's subject to it:

  • Single taxpayers whose income exceeds $200,000.
  • Married couples filing jointly who together earn more than $250,000.
  • Married spouses filing separately who individually earn more than $125,000.

The surtax is levied on whichever of the following is less—modified adjusted gross income above the threshold, or net investment income. They break down as follows:

Modified adjusted gross income (MAGI) Net investment income
   Adjusted gross income (AGI)
+ Foreign earned income exclusion

= Modified adjusted gross income
+ Dividends
+ Capital gains
+ Rent and royalty income
+ Nonqualified annuities
+ Income from businesses that are passive activities to the taxpayer
– Expenses directly allocated to the production of these income sources

= Net investment income

Importantly, interest from tax-exempt municipal bonds is not included in net investment income.

How the Medicare surtax works

Of course, every taxpayer's situation is unique, and, again, you may want to work with a tax professional for specific guidance. That said, here are three simple examples to illustrate how the new surtax works:

  • A single individual has $100,000 in MAGI, of which $75,000 is wages and $25,000 is net investment income. Because he doesn't exceed the $200,000 threshold, he doesn't owe the 3.8% surtax.
  • A single individual has $225,000 in MAGI, of which $100,000 is wages and $125,000 is net investment income. Because she's $25,000 over the $200,000 threshold, she owes $950 (3.8% × $25,000).
  • A married couple filing jointly has $400,000 in MAGI, of which $325,000 is wages and $75,000 is net investment income. Their MAGI is $150,000 over the $250,000 threshold for married couples filing jointly. They'll owe the 3.8% surtax on their $75,000 of net investment income, because it is less than the amount by which they exceed the threshold. Their total investment surtax will be $2,850 (3.8% × $75,000).

"What does this mean for me?"

As an investor, you're probably wondering how all of this will affect your portfolio.

Sarah Hammer"The short answer is, the Medicare investment surtax doesn't change Vanguard's asset location recommendations," said Sarah Hammer, a senior analyst with Vanguard Investment Strategy Group.

"Investors should continue to place tax-inefficient assets in tax-deferred accounts, and tax-efficient investments in taxable accounts," Ms. Hammer said. "This can help maximize after-tax returns in your taxable accounts and maximize the benefits of your tax-deferred accounts."

Also, the investment surtax does not apply to municipal bond interest. That may be a good reason to consider incorporating municipal bonds in your portfolio, Ms. Hammer said.

Here are some other things you can do if you're concerned about taxes:

  • Be a tax-efficient investor. Use tax-advantaged accounts (see below) to rebalance your asset allocation or sell appreciated positions. This may provide better after-tax returns than conducting similar transactions in a taxable account.
  • Consider index funds. Index funds have a high potential for tax efficiency. If income and capital gains tax rates rise in the future, the hurdle for holding actively managed funds in taxable accounts will increase as well. Learn more »
  • Take full advantage of tax-advantaged accounts. Maximize the use of tax-advantaged accounts, such as traditional and Roth 401(k)s, IRAs, and 529 college savings plans.

We recommend that you consult a tax or financial advisor about your individual situation.

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