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IRS Issues Proposed Rules for New Medicare Tax on High Wage Earners’ Net Investment Income; Whether Tax Applies to 404(k) Dividends is Unclear

The U.S. Internal Revenue Service (“IRS”) recently issued proposed regulations regarding a new 3.8 percent Medicare tax on the “net investment income” of high wage earners ($200,000 for single filers, $250,000 for joint filers, and $125,000 for married persons filing separately), effective January 1, 2013.  Under the proposed regulations, net investment income includes income from interest, dividends, annuities, royalties, and rents, less any allowable deductions.  Notably, the proposed regulations exclude from net investment income distributions from most tax-favored retirement plans, such as those described in Internal Revenue Code (“Code”) sections 401(a), 403(a), 403(b), 408, 408A, or 457(b).  Yet, the proposed regulations did not directly address whether 404(k) dividends paid under an Employee Stock Ownership Plan (“ESOP”), including a 401(k) plan with an ESOP component, would be included in net investment income.

Code section 404(k) permits plan participants, to the extent provided under the plan, to elect to receive dividends on employer stock either (1) paid directly to them in cash or (2) paid to the plan and reinvested in additional shares of employer stock.  Arguably, if the participant elects to have the dividends paid to the plan and reinvested in additional employer stock, this tax should not apply because the participant will ultimately receive the value of the dividend as a distribution from the plan, which would be reported on Form 1099-R.  But if the participant elects to receive the dividends directly in cash, it is possible the tax might apply because such dividends, reported on Form 1099-DIV, are otherwise taxed as “ordinary dividends.”  Absent additional guidance from the IRS, it is unclear whether and to what extent 404(k) dividends should be included as net investment income for purposes of this tax.  The proposed regulations can be found here.

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