On January 1, 2013, the 3.8% Medicare surtax, passed by Congress in 2010 to help pay for Obamacare, takes effect.  The 3.8% surtax is in addition to any income tax owed and applies to both individuals and trusts and estates.   Let us examine how the 3.8% surtax will apply in 2013 to individuals and to those trusts and estates which are required to file income tax returns. 

          With individual taxpayers the 3.8% Medicare surtax applies to the lesser of the taxpayer’s “Net Investment Income” or the excess of the taxpayer’s “Modified Adjusted Gross Income” (MAGI) over  the applicable threshold:  $125,000 (married filing separately), $250,000 (married filing jointly and qualified widowers), or $200,000 (single filers).   Thus, the amount by which MAGI exceeds the applicable threshold limits how much of the net investment income is subject to the 3.8% surtax.   

          With taxable estates or trusts, however, the surtax applies to the lesser of its “Undistributed Net Investment Income” or the excess of an estate’s or trust’s “Adjusted Gross Income” (AGI) above $11,650.  Thus, the amount by which AGI exceeds $11,650 limits how much of the net investment income is subject to the 3.8% surtax.  

          Trusts and estates with an AGI above $11,650 also pay the highest tax rates on their excess income (39.6 % in 2013).  By contrast, individuals do not reach the highest income tax bracket until they earn above $300,000.  Accordingly, trustees often distribute out any otherwise taxable trust income to their beneficiaries, who typically are in lower tax brackets.

          The surtax applies to bypass trusts, marital trusts, and to third party special needs trust for the benefit of persons with special needs receiving needs based benefits (e.g., SSI and/or Medi-Cal).  It does not apply to revocable living trusts, to charitable remainder trusts, or to self-settled (first party) special needs trusts. 

          For example, consider a third party special needs trust established at the death of a parent for the benefit of a surviving child with special needs.  Because this special needs trust is a third party special needs trust (and not a self settled first party special needs trust) it is required to file its own income tax returns.  Let us say that this special needs trust has $15,000 in adjusted gross income, of which $5,000 is taxable net investment income and the rest is exempt municipal bond interest.  In this case,  $3,350 of the $5,000 net investment income would be subject to the 3.8% surtax because the trust’s AGI exceeds $11,650 by $3,350 which is the lesser amount (the ceiling).  Here the 3.8% surtax owed is only $127.  The trust’s income tax owed on the same $3,350 is $1,327. 

          What is Net Investment Income?  It is interest, dividends, royalties, rents, unless derived in the ordinary course of a trade or business.   The surtax excludes retirement income from IRA and 401(k) distributions, are still subject to income tax.  Thus, if a trust or estate is the beneficiary of an IRA or 401(k) plan, then the trust’s receipt of such retirement distributions are excluded from the 3.8 % Medicare surtax, which is still subject to income tax (a good reason to distribute to the beneficiary).  This may happen when a special needs trust is named as the plan participant’s death beneficiary in order to preserve SSI and Medi-Cal eligibility of a person with special needs.

          Where the trustee can either distribute out the trust’s net investment income and/or otherwise invest in non taxable assets the surtax can be reduced.  The trustee’s ability to distribute out net investment income will be affected by the terms of the trust and California law. 


“Serving Lake and Mendocino Counties for nineteen years, the Law Office of Dennis Fordham focuses on legacy and estate planning, trust and probate administration, and special needs planning. We are here for you. 870 South Main Street Lakeport, California 95453-4801. Phone: 707-263-3235.”