Avoid the Obamacare Surtax With Better Tax Planning

A surprise birthday party may be fun, a surprise tax bill is not. Many high earners are getting hit with the Obamacare surtax, but with a little tax planning, they could avoid getting surprised by a pesky tax bill.

Support for health care creates a bit of a conundrum for the pocketbooks of high earners.

Why? The higher the income, the more money those in support of health care for everyone will have to pay in taxes. The 3.8% 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 it means you are making more money than over 90% of Americans. Of course, I don’t think that will make it sting any less.

Where Did the Obamacare Surtax Come From?

To help fund the Affordable Care Act (also dubbed Obamacare), there was a 3.8% surtax levied against high 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.

How the 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 investment income above the thresholds. For example, if you make $100,000 you won’t owe any additional taxes.

But let’s say you are a single earner making $180,000 of AGI each year and experience a one-time gain of $100,000 from selling long-held shares (this could also be a home sale or employee 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.

When I listed the above income ranges, I bet you just thought about your paycheck. Only considering their paychecks is why so many people are surprised when they get hit with this tax for the first time. (For related reading, see: New Taxes Under the Affordable Care Act.)

What Will and Won't Be Counted as Investment Income

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

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 Surtax Sting

You may not be able to completely avoid the ACA surtax, but with a little 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. 
  2. Don’t ignore tax harvesting. It amazes me how few 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% surtax is 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 you 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. The lower your AGI (the number at the bottom of the Form 1040), the lower the amount of your income that will be subject to the 3.8% surtax. 
  4. Need another reason to contribute to your retirement plan? Making contributions to your 401(k), 403(b) or pension will lower AGI. You can also make charitable contributions from your IRA assets if you are over 70.5.

How to Deal With Retirement Income

Income from retirement accounts like IRAs, pensions and 401(k)s are not directly subject to the 3.8% surtax. That being said, they may lift other forms of income into the 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 IRAs, 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 surtax burden.

Roth IRA to the Rescue

Payment from a Roth IRA 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 types 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. (For more from this author, see: Which Is Best: A Roth IRA or Roth 401(k)?)

You Can Escape the Healthcare Surtax With Death

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.

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

Live for today, plan for tomorrow.

(For more from this author, see: Avoid These 9 Traps to Become a Millionaire.)


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