3.8% Medicare Tax on Net Income from Investments

By ZM Ishmurzina

The US Patient Protection and Affordable Care Act (PPACA) or so-called “Obamacare” was upheld by the Supreme Court in June 2012. Earlier we wrote an article about Obamacare and American Expats. American expats living overseas are exempt from a penalty tax and from the requirement to obtain a health insurance under Affordable Care Act. However, some high-income earners will have to pay 3.8% Medicare tax on income from investments when they file US expat tax returns on overseas income. This 3.8% Medicare tax has become effective on January 1, 2013.

This is an email from one of our clients, American expats living overseas. “I plan to sell several stocks that I have owned since 1991. I estimate that the gross income will exceed $250,000 in 2013. I wonder whether I will owe 3.8% Medicare tax on income from investments since I live overseas.”

Expat tax guide to 3.8% Medicare tax on Net Investment Income

What is Net Investment Income?

The investment income includes a wide range of passive income. Net Investment Income is calculated net of any allocated expenses. The below categories of income are included for the purposes of 3.8% Medicare tax.

  • Interest Income from various investments. Tax-free interest from municipal bonds is not included.
  • Dividend Income
  • Capital gains from selling stocks and other investments in taxable brokerage accounts. The transactions in Roth IRA and Traditional IRA accounts are not included.
  • Capital gains from transactions in financial instruments and commoditiees
  • Capital distributions from mutual funds
  • Capital gain from selling investment real estate
  • Rental income
  • Income from royalties
  • Income from annuities
  • Capital gains from selling passive interest in partnerships and S-corporation
  • Income from passive partnership investments and passive S-corporation interest

Are distributions from IRA, Roth IRA and other qualified retirement plans subject to 3.8% Medicare tax on Net Investment Income?

To get more information about a list of retirement plans, please visit this IRS website about Qualified retirement plans. Americans living abroad should know that distributions from qualified retirement plans and IRAs as well as tax-exempt municipal bonds are not subject to 3.8% Medicare tax on income from investments. Qualified retirement plans are Employee Stock Ownership Plan like 401(k), 403(b) or 457(b) plan, an employer-sponsored defined benefit plan, profit sharing plan, and money purchase plan. Congress wants to encourage taxpayers to invest in municipal bonds because cities, counties and states issue municipal bonds. This money is used to invest in public projects and stimulates the economy.

Is the capital gain from the sale of personal residence subject to Net Investment Income tax?

This tax does not apply to the gain that is excluded from the taxable income per IRC Section 121.

What is the income tax bracket of American expats who are subject to Net Investment Income tax?

American expats must be aware that only certain categories of Americans living abroad will be subject to 3.8% Medicare tax on income from investments. The modified adjusted gross income (MAGI) must exceed the following amounts:

  1. Single filer with MAGI (modified adjusted gross income) over $200,000
  2. Married filing jointly with MAGI over $250,000
  3. Married filing separately with MAGI over $125,000

Are Foreign nationals with passive investments in the USA required to pay 3.8% Medicare Net Investment income tax?

Nonresident aliens with interest income, dividends and capital gains from the USA are exempt from 3.8% Medicare tax on income from investments. The same rule applies to foreign investors in USA real estate. This issue is very important since the number of foreign investors in the US real estate has increased significantly since the start of foreclosure crisis.

Are American expats who decide to renounce US citizenship required to pay 3.8% Medicare tax on investment income?

The increasing number of Americans living abroad renounce citizenship. American expats are subject to the “exit tax” if they are covered expatriates. The exit tax is assessed as if the worldwide assets were sold a day before expatriation. Covered expatriates are subject to 3.8% Medicare tax on net investment income.

Conclusion

American expats living abroad must realize that the tax law is changing constantly. 3.8% Medicare tax is one of the latest developments that affect US expat tax planning and preparation. Understanding foreign income exclusion, foreign housing exclusion and foreign credit is not sufficient to file a US expat tax return. Americans living abroad are advised to contact an expat tax CPA/preparer that provides international tax services. To learn more about the services provided by Artio Partners, please click here.