What's the Right Way for Clients to Calculate Their Medicare Surtaxes?

In the fourth and final installment to his detailed series on Medicare surtaxes, financial guru Julian Block explains how your clients (and you) should properly calculate these to avoid getting in hot water with the IRS.

Sep 17th 2020
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Several previous columns dealt with the basics of the Medicare surtax of 3.8 percent on investment income. This one gives examples of how taxpayers calculate their surtaxes. First, though, let’s recap basic terms like “modified adjusted gross income” (MAGI) and “Net Investment Income” (NII).

Surtaxes are keyed to MAGI. Taxpayers need to concern themselves with surtaxes when a MAGI amount exceeds an applicable threshold.

The threshold amounts are based on filing status. They are $250,000 for joint filers; $125,000 for married couples filing separate returns; and $200,000 for single persons, heads of household and qualifying widows/widowers (surviving spouses who qualify for the same breaks as married couples for two years after a spouse’s death).

For most persons, MAGI and adjusted gross income are the same. “Modified” applies only to individuals who live outside the United States and avail themselves of the foreign earned income exclusion. Expatriates have to add back excluded amounts.

Does it absolutely follow that taxpayers are liable for the 3.8 percent tax when their MAGIs exceed their threshold amount? Absolutely not.

Congress told the IRS to impose the tax on the lesser of (A) NII or (B) the excess of (1) MAGI over (2) the threshold amount. Dear Readers, as we look at some examples for 2020, remember the agency’s marching orders.

Here’s how joint filers John and Abigail do the straightforward calculations for their 0.9 percent surtax on earned income. His wages are $180,000. Her net profit from self-employment is $200,000. Total earnings are $380,000. Threshold for joint filers is $250,000. Their 0.9 percent tax is $11,700 (0.9 percent of $130,000, the amount by which $380,000 exceeds $250,000.)

Joint filers Rudolph and Flavia need to determine their 3.8 percent tax. Unlike John and Abigail, their calculations aren’t straightforward.

NII is $100,000. MAGI is $300,000. Threshold for joint filers is $250,000. Their surtax tab turns out to be $1,900—3.8 percent of $50,000 ($300,000 MAGI minus $250,000 threshold).

Where does that $50,000 come from? $50,000 is less than their $100,000 NII.

Single filer Sally similarly needs to calculate the 3.8 percent tax. NII is $100,000. MAGI is $400,000. Threshold is $200,000. Sally arrives at a surtax of $3,800—3.8 percent on NII of $100,000.

Why does she use $100,000? Because $100,000 is less than $200,000 (MAGI of $400,000 reduced by $200,000 threshold).

Separate calculations. An adamant IRS insists that taxpayers make separate calculations for the 0.9 percent levy and the 3.8 percent levy to see whether they could be liable for both taxes.

Florence files as a single person. She’s one of those taxpayers who needs to calculate the two taxes. Earnings are $180,000. NII is $60,000. MAGI is $220,000. Threshold for single persons is $200,000. Flo figures that her 0.9 percent surtax is zero.

Why does the IRS agree with Flo’s figure? Because her $200,000 threshold exceeds her $180,000 earnings.

The 3.8 percent tax is another story. The IRS requires her to pay $760—3.8 percent of $20,000. Why $20,000? Because that’s the amount by which $220,000 exceeds $200,000.

Let’s end with Andrea, another single filer, and someone similarly required to do double calculations. Earnings are $300,000. NII is $60,000. MAGI is $400,000. Threshold is $200,000.

Andrea’s 0.9 percent surtax turns out to be $900—0.9 percent of $100,000. That’s the amount by which $300,000 exceeds $200,000.

What about the 3.8 percent tax? It punches in at $2,280 (3.8 percent of $60,000). Why $60,000, wonder some of my Dear Readers? Because $60,000, consistent with my previous admonition, is less than $200,000 (MAGI of $400,000 minus threshold of $200,000). Andrea’s aggregate additional assessment: $3,180 ($900 plus $2,280).

Am I done discussing the 3.8 percent tax? No. “I’ll be back,” to reprise a line, or variations on it, in The Terminator movies.

A few columns down the road, I’ll focus on how the tax affects homeowners who reap seven-figure-and-higher gains from sales of their principal (year-round) mansions that they owned and used for at least two years out of the five-year period that ends on the sale date. Their gains enormously exceed profit exclusions for home sales that go as high as $500,00 for married couples filing jointly and drop down to $250,000 for married couples filing separately or single persons. Internal Revenue Code Section 121 authorizes the exclusions.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting). 

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