3.8% Obamacare Medicare Surtax and How to Avoid It. (2024)

The 3.8% Obamacare Surtax and how to avoid it. This Medicare surtax can be avoided or minimized with a little proactive tax planning. Don’t be surprised if your LA financial advisor or Palm Springs financial planner doesn’t take a proactive approach to help you minimize your tax bills. Proactive tax planning is imperative for those with large incomes. Tax planning is even more valuable for those making big incomes in California, a high tax state.

A surprise Birthday Party may be fun, and a surprise tax bill is not. Many people in Los Angeles are getting hit with the Obamacare surtax, with a little tax planning man could avoid getting surprised with a pesky tax bill.

I’m a Financial Planner in LA where people tend to skew more liberal politically compared to other parts of the county. If you were to randomly pick people on the street and ask them if they support Medicare for all or healthcare for everyone, you would probably get more responses of yes than no. However, support of universal healthcare in SoCal creates a bit of a conundrum for our pocketbooks. California already has some of the highest state-level income taxes in the country, topping out at 13.3%. This is on top of a top 37% Federal Tax Bracket. Taxpayers in the top income brackets are likely to also be subject to an additional 3.8% Medicare Surtax on much of their income.

Why? Income levels tend to be higher in California aka the Golden State. The higher the income, the more money those in support of healthcare for everyone will have to pay in taxes. The 3.8% medicare surtax on higher incomes seems to be the tax that surprises and annoys many people who find themselves getting hit with it for the first time. The only good news about paying this surtax is that it means you are making more money than 90% plus of Americans. Of course, I don’t think that will make that big tax bill sting any less.

Where did the Obamacare Medicare Surtax come from?

To help fund the Affordable Care Act (also dubbed Obamacare), there was a 3.8% surtax levied against higher incomes. This specific tax took effect in 2013 and, according to the Tax Policy Center, is expected to bring in nearly 30 billion dollars of tax revenue.

This surtax begins for those making just $200,000. Arguably a great income, but those making it don’t exactly scream rich here in La La Land. The surtax was supposed to be a tax on the RICHEST Americans and, for the most part, it is. It is worth pointing out that there is a difference between income and wealth. Around three-fourths of the surtax, revenue comes from households earning more than $1 million per year. According to the Wall Street Journal, these households will owe an average of $37,000 each. While households earning between $200,000 and $500,000 will owe an average of $200 each. As your income grows, likely so will the amount you owe for the Medicare Surtax.

The surcharge may not hit you now but beware. Statistics can often lie. The averages above conceal wide variations in real people’s tax bills. The Obamacare surtax trigger points are not adjusted for inflation. Things like big investment windfalls, home sales, or stock option exercises, could increase your income subject to this tax. The medicare surtax considers all forms of income, not just your salary from working.

There are likely many people earning just above $200,000 whose surtax bill will be minimal, artificially bringing down the “average” bill for those between $200,000 and $500,000. To be clearer if you earned $500,000, you would owe $11,400 from just this surtax. I should point out, what many of you already know, that $200,000 doesn’t go that far when trying to buy a house in Los Angeles.

How the Obamacare Medicare Tax Works

There is a flat surtax of 3.8% on net investment income for married couples who earn more than $250,000 of adjusted gross income (AGI). For single filers, the threshold is just $200,000. Another example of the marriage penalty at work in our tax code.

The levy is only for investment income above the thresholds. For example, if you make $100,000, you won’t owe any additional taxes.

However, let’s say you are a single earner making $180,000 of AGI each year and experienced a one-time gain of $100,000 from selling long-held stock shares (this could also be a home sale or employer stock options.) This would increase your income to $280,000, making $80,000 of your total income subject to the 3.8% surtax. This would result in you owing roughly $3,040 in extra taxes just from the Medicare Surtax.

When I listed the above income ranges, I bet you just thought about your own paycheck. Only considering their paychecks is why so many people are surprised when they get hit with this tax for the first time.

What will be counted as investment income?

Things like interest, dividends, capital gains, rental income, royalties, and even some passive investment income will be counted as investment income.

What is not counted as investment income?

Generally speaking, you can exclude income from municipal bonds, partnership income, and S Corporations if you are actively participating. There are also certain types of rental income and some capital gains, for selling a business, that may be excluded as well.

How to minimize the Medicare Surtax sting

You may not be able to completely avoid the ACA surtax, but with a little smart tax planning, you should be able to minimize it. Here are a few smart tax planning tips.

1. Before you sell a highly appreciated home, consider your income and this tax. Many couples will have nothing to worry about as you can potentially exclude up to $500,000 ($250,000 for singles) profit on the sale of a primary residence. While $500,000 is a nice exemption, that doesn’t go as far around Los Angeles or Palm Springs as it does in Arkansas.
2. Don’t ignore tax harvesting. I’ve been doing this since 2004 for clients and it still amazes me how few so-called financial advisors take the time to do this. It is extra work, but it can make a huge difference on net investor returns. The 3.8% Obamacare surtax is also levied on net investment income. If you are winning big on one holding, you may have losses you can realize on other holdings to help minimize your tax bill. If I’m making your eyes cross, don’t worry. A good fiduciary financial planner can help take care of it for you.
3. Look for ways to minimize your AGI. The lower your AGI (the number at the bottom of the TAX-FORM 1040) the lower the amount of your income will be subject to the 3.8% surtax.
4. Need another reason to contribute to your retirement plan? Making contributions to your 401k, 403b or pension will lower your AGI. You can also make charitable contributions from your IRA assets if you are over 70 ½. Here are some strategies to make the most of your RMDs.

How to deal with retirement income

Income from retirement accounts like IRA’s, pensions and 401ks are not directly subject to the 3.8% surtax. That being said, they may lift other forms of income into the medicare surtax realm. Let me give you an example. Let’s say a couple did a great job saving for retirement and have $300,000 in retirement income from IRA’s, social security and a Defined Benefit Pension plan. In this case, they wouldn’t owe the surtax since all of this income came from retirement accounts. Now, let’s say they also have $20,000 in capital gains on their stock portfolio. They would owe the 3.8% Obamacare surtax on the full $20,000 since this amount would be on top of their retirement income. Having a more tax-efficient portfolio could help alleviate some of this extra MEDICAREsurtax burden.

ROTH IRA to the rescue

Payment from a ROTH IRA or ROTH 401(k) comes out tax-free and doesn’t raise taxable income. This can also help minimize the burden of the 3.8% surtax. This is where diversification of your retirement account taxation can really pay off. If you will have certain years with high investment income, you will want to adjust your withdrawal strategy to minimize overall taxes and the 3.8% surtax. Look for ways to increase your tax-free income as your march towards financial freedom.

You Can Escape the Healthcare Surtax By Dying

Your heir or heirs receive a step-up in basis when you pass away. So, if you hold investments up until the time of your passing, there won’t be capital gains taxes or the ACA surtax on the earnings prior to your passing. Of course, you have to die, so not always a great option. This only applies to taxable accounts. Your heirs will owe taxes on withdrawals from Inherited IRAs.

Now that we’ve covered death and taxes, it is time to wrap this up.

Have you been hit with the Medicare Surtax? Feel free to reach out and see how we can help you keep more of your hard-earned money. Tax planning should be part of your comprehensive financial plan. If your so-called financial advisor does not help you minimize your taxes, then it is likely time to upgrade to a fiduciary financial planner who offers proactive tax planning.

Live for Today, Plan for Tomorrow.

DAVID RAE, CFP®, AIF® is a Los Angeles-based retirement planner with DRM Wealth Management. He has been helping friends of the LGBT community reach their financial goals for over a decade. He is a regular contributor to Advocate Magazine, Forbes.com, Huffington Post as well as the author of the Financial Planner Los Angeles Blog.Follow him onFacebook, orvia his website www.davidraefp.com

The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual.

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