I think this quote from the August 2013 issue of the Journal of Accountancy sums it up pretty well:
“The new surtax on net investment income will come as a surprise to many individuals… Even more surprising for individuals will be that most tax credits (e.g. the foreign tax credit) available to offset the income tax of chapter 1 of the Code will be unavailable to offset the new surtax in chapter 2A.” and “Although chapter 2A is titled “Unearned Income Medicare Contribution,” the amounts collected from this tax are not designated for the Medicare trust fund” (and therefore not considered a social security tax).
I have to admit that I was one of those surprised individuals, and I have been aware of and closely following the surtax since it was passed into lawas a part of the Patient Protection and Affordable Care Act of 2010. However, I always assumed it was nothing to worry about for most of my clients because it would either be a) an income tax (offset by foreign tax credits) or b) a social security tax (avoided by using the US-NL totalization agreement). Unfortunately, it is neither of these. It is a “surtax” with its own tax code section, which means a true double tax, even for people paying a very high rate of tax on the same income in a foreign country.
So this presents a whole new aspect of year-end tax planning. In the past when reviewing the client’s situation for year-end tax planning around investment income I mainly wanted to make sure that:
1) They don’t have a net short-term capital gain, because this is not tax-efficient, even if you can offset with foreign tax credits
2) The client does not run out of foreign tax credits unnecessarily (and then owe US tax, when they could potentially wait until they have built up more credits)
3) Foreign tax credits do not expire (after 10 years) 4) We don’t let the tax tail wag the investment dog too much…
The new surtax as of 2013, combined with the higher maximum tax rate on capital gains adds some new considerations:
5) To the extent possible, we want to avoid the new surtax of 3.8% by keeping Modified AGI* for the client below $250K (Married Filing Joint), $200K (Single / Head of Household) or $125K (Married Filing Separately).
6) If this is not possible, then to the extent possible we want to avoid being in the 20% tax bracket by keeping Modified AGI* below $450K (Married Filing Joint), $425K (Head of Household), $400K (Single) or $225K (Married Filing Separately).
7) Taking all of this into account, and considering the level of a client’s unrealized capital gains, we want to make sure we don’t end up having to realize a lot of gains when foreign tax credits start to expire, to the extent that it costs them an additional 3.8% because the gains exceed the threshold.
To elaborate on the last item (7), assume this is Year 1 and a married client has a stable salary of $100K, unrealized capital gains of $300K, and significant foreign tax credits that will expire in Year 2. If they wait until Year 2 and then realize all $300K of capital gains, they can still potentially pay zero income tax on this gain (after foreign tax credits), and it is all taxed at 15% since the 20% tax bracket starts at $450K. However, $150K of the gain will be subject to the 3.8% surtax, so the additional cost will be $5,700 (3.8% * $150K). It would have been better to realize $150K in year 1 and $150K in year 2, all else being equal.
There are a several articles out there that give advice about “normal” (non-expat) planning for the new surtax, so I won’t go into detail about this. I can recommend this article by Michael Kitces.
*Modified AGI in most cases means Adjusted Gross Income after adding back the Foreign Earned Income and Housing Exclusions. For most people this is your wages, interest, dividends, and capital gains added together.