As the 2013 tax preparation season wound to a close in April of this year, many investors discovered for the first time a costly new line item on their tax return: "Other Taxes" on Line 60 of their Form 1040, where they reported the new 3.8% "Medicare surtax" on net investment income that just took effect in the past year. While "only" a 3.8% rate, the new tax is significant for many types of investment income eligible for a preferential rate; after all, adding 3.8% to a 15% long-term capital gains rate is actually a 25.3% relative increase in tax burden!
Fortunately, the new 3.8% surtax on net investment income applies only to investment income, and not distribution from (or conversions of) retirement accounts like 401(k)s, 403(b)s, and IRAs. However, the reality is that because the tax only applies to investment income above certain income thresholds, it's possible for "non"-investment income like retirement distributions to cause the surtax on other investment income by pushing it over the line. The end result: even types of income not directly subject to the tax end out indirectly causing the 3.8% surtax after all!
Given this dynamic, investors whose investment income is in the "crossover zone" and straddles the income threshold - such that only a portion of their investment income is subject to the surtax - have a unique planning opportunity to shift income into other years where they do not face the crossover zone. In fact, there are even situations where it can pay to shift retirement distributions or conversions into a year where overall income is higher if it avoids the crossover zone (and of course, shifting income into years when income is lower is often also favorable). At a minimum, though, recognizing the crossover means acknowledging that the marginal tax rate may be higher than just the tax bracket alone, leading to additional tax planning opportunities but requiring more careful analysis as well!