Medicare Tax: Its Effect on Investment Income

July 20, 2012

The scope of the Patient Protection and Affordable Care Act (PPACA) has implications beyond individual health care and insurance. To increase Medicare funding, high net worth individuals will see an increase in taxes on net investment income. The tax will take effect on non-business income from dividends, interest, annuities, royalties, rents, and capital gains. The levied tax will be 3.8% on the amount of investment income that causes an individual’s net income to exceed $200,000 (or $250,000 for joint-filers).

While the Medicare Tax seems straightforward, it is highly complex in that its definition of investment income is broad. The tax applies directly to nonbusiness interest, dividends, annuities, royalties, and rents. Nonbusiness interest includes but is not limited to CDs (certificate of deposit) and corporate bonds. A certificate of deposit is issued by a bank and entitles the bearer to a fixed interest rate on the amount of the note, with a maturity date of up to five years. The bearer of the CD will earn interest income depending on the compounding periods of interest. For example, if you purchased a $5,000 CD with a stated rate of 10% annually and one year to maturity, you would earn $500 dollars taxable interest and the CD would be worth $5,500. Corporate bonds are issued with a future value of $1,000 and interest is accrued based on the present value of the bond. If the purchaser of the bond buys it at a discount, less than the $1,000 par value, they are taxed on the interest income earned until the bonds maturity and the issuer repays the bond at par value. If you purchase a corporate bond at $900, you will earn interest income of $100 at the bond’s maturity and you will be taxed 3.8% per the PPACA.

Dividends, rent, and capital gains are easier to grasp. Depending on the corporation, companies will distribute net income on a per share basis as dividends to shareholders. If you own stock in the company, and that company issues dividends, you are taxed on the dividend income. Rent refers to income generated from real estate that you own and rent to others. The monthly fee that they pay you to live on your property is cumulatively taxed at the year-end. Capital gains arise from the sale of an asset at market value, higher than the purchase price for which you bought it. For instance, if you purchased a single share of stock in Apple (AAPL) at $22.00 following its Initial Public Offering, and you sold that stock today at $604.43, you would be taxed on the capital gains of $582.43 (If you purchased a few thousand shares you would be a millionaire!).

For investors in partnerships and S-Corporations, the Medicare Tax affects their percentage ownership of the company upon disposition or sale. For example, if you invested $10,000,000 in an S-Corp and retained 20% ownership, the company would have a net worth of $50,000,000. Down the road, if the company was sold at a fair market price of $100,000,000, or you sold your ownership of the company and its appreciated net worth was $100,000,000, you would realize $20,000,000 in capital gains ($10,000,000 in excess of your original investment). The 3.8% Medicare Tax is to be levied on the $10,000,000 in capital gains you receive through the sale of your ownership.

Fortunately, the Medicare Tax does not extend to all of us. Individuals whose net income, adjusted to include the above non-business income, exceed $200,000 or couples whom exceed $250,000 will see the effects of the tax. The aim of the tax is to further fund Medicare, but it could spur a certain degree of market volatility. Investors might look to sell their capital assets before the tax takes affect an incur only the standard income tax.

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