Does Medicare Tax Apply To Capital Gains?

Capital gains taxes are something every investor must contend with. But these taxes aren’t limited to just short and long-term gains. There’s another tax called the Medicare tax that can also get thrown in. It doesn’t happen to everyone, though. In this article, we’ll look at who the Medicare tax effects.

Long-Term Capital Gains Tax Rates

As a recap, short-term capital gains are treated just like ordinary income. These are gains on investments that are held for at least one year. Long-term capital gain taxes are more favorable and are taxed at less than the ordinary income tax rate.

The 2020 long-term capital gains tax rates are broken down into three different rates — 0%, 15%, 20%. The rate you fall under depends on your income and filing status. The table below outlines the 2020 long-term capital gains tax rates.

Additionally, you’ll have to pay state long-term capital gains taxes. There may also be a 1-2% transfer tax at the local taxing level. With short and long-term taxes covered, we can now look at when the medicare tax comes into play.

Medicare Surtax

The Medicare tax is also known as the Medicare surtax or net investment income tax (NIIT). It is part of IRC Section 1411(c). The tax became effective in 2013 and is part of the Affordable Care Act of 2010. While it is a tax on investment income, funds from the tax are used for Medicare expansion. Hence the word Medicare in some of the tax’s terminology.

The Medicare surtax is a 3.8% tax. It is a tax on combined net investment income and modified adjusted gross income (MAGI) of more than $200,000 for single filers and more than $250,000 for married filing jointly. It applies to individuals, estates, and trusts. Of course, like other taxes, the Medicare surtax only applies after any losses/expenses have been factored in.

For example, if an investor had $180k in income from investments and MAGI, the investor would not incur Medicare surtax. However, if the investor then sold an additional $50k of long-term stock, putting total income at $230k, $30k of it would be subject to Medicare surtax.

The Medicare surtax applies to the following gross investment income types:

• Interest
• Dividends
• Capital gains
• Capital gains distributions from mutual funds
• Royalties
• Annuities
• Passive business activities
• Rents

The following don’t count as taxable income for the Medicare surtax:

• Muni bond income
• Income from non-passive business activities, i.e., actively participates in income (direct real estate, for example)
• Gains from dispositions of passive ownership interests in partnership or S-corp
• Income and gains from the business of trading in financial instruments and commodities

You don’t have to be a high-income earner to be hit with the Medicare surtax. Through a windfall, the middle class can be affected as well.

Don’t confuse the Medicare surtax with the Medicare payroll tax, which is also called the Additional Medicare Tax (AMT), Obamacare tax, and even the Medicare surtax. The AMT is a 1.45% (for 2020) payroll tax on wages. It’s easy to confuse these two taxes, but they are two different taxes.

Offsetting The Medicare Surtax 

Besides selling investments for a loss, which will reduce taxable gains, there are a couple of other ways to potentially offset the impact of the Medicare surtax.

One is called tax-loss harvesting. Tax-loss harvesting is performed on equity portfolios and is generally automated. The strategy sells losing positions, takes those proceeds, and buys a replacement security, maintaining the portfolio’s target allocation in the process. Tax-loss harvesting also aims to avoid wash sales.

Planning the sale of any assets before year-end can be another strategic move to help offset gains. For example, you might plan to sell some losing positions in October or November rather than waiting until the very end of the year (i.e., December). 

For the above strategies, you’ll always want to discuss your specific situations with your tax advisor.

The Medicare surtax affects high-income earners and is a static 3.8% tax. We’ve discussed how this tax is applied and a few ways to mitigate its impact, which is done best by working with your tax advisor.