Planning for 2013’s 3.8% Medicare Surtax and Other Income Tax Rate Changes

On June 28, 2012, the Supreme Court upheld the Patient Protection and Affordable Care Act of 2010 in a 5-4 decision.  One of the Act’s more significant provisions is the 3.8% Medicare surtax on net investment income effective January 1, 2013.  Furthermore, absent Congressional action, various tax rates are set to increase beginning in 2013: the top ordinary income tax rate will increase from 35% to 39.6%, the long-term capital gain tax rate will jump from 15% to 20% and qualified dividends will be taxed as ordinary income instead of at the 15% long-term capital gain tax rate.  These drastic changes on the horizon have increased the significance of tax planning for 2012.  Classic tax planning would normally include deferring income but this may not be the case for 2012.

The Medicare surtax is designed to affect “high-income” taxpayers, who are defined as individuals with modified adjusted gross income (MAGI) of more than $200,000, or $250,000 if married filing jointly.  The Medicare surtax is imposed on the lesser of net investment income or the excess (if any) of MAGI over the threshold amounts above.  The Medicare surtax also applies to estates and trusts.

Net investment income is defined broadly to include the following items, reduced by any deductions allocable to such income:

  • Interest, dividends, royalties, annuities and rents
  • Income derived from passive activities
  • Income derived from trading financial instruments and commodities
  • Net capital gains derived from the disposition of property (other than property held in an active trade or business)

Some of the major items that are not included in net investment income are as follows:

  • Active trade or business income (except for the trade or businesses of trading financial instruments or commodities)
  • Gain on sale of an active interest in a partnership or S corporation
  • Distributions from IRAs or qualified retirement plans
  • Income from tax-exempt municipal bonds
  • Tax deferred non-qualified annuities
  • Income taken into account for self-employment purposes
  • Portion of capital gain on the sale of a principal residence that is excluded from income under IRC Section 121 (up to $250,000 for single taxpayers and $500,000 for married couples).  Only the portion of capital gain that exceeds the exclusion as well as profits on the sales of rentals and second homes may be subject to the Medicare surtax.

It is important to note that even though certain items are not considered net investment income, they still can trigger the Medicare surtax by increasing your MAGI above the threshold amounts.

Also beginning January 1, 2013, there will be an additional 0.9% tax on the Medicare portion of payroll and self-employment taxes.  This 0.9% tax will be assessed on earned income in excess of $200,000 for individual and $250,000 for joint filers.

If your MAGI in 2013 and future years will likely be above the threshold amounts, there are various tax planning strategies that can be implemented to help minimize the impact of the Medicare surtax and other tax increases as follows:

  • Sale of assets – Capital gain on the sale of assets after January 1, 2013 could trigger the Medicare surtax.  Accelerating the sale of the assets into 2012 may help to avoid the surtax as well as lock in the 15% capital gains rate if the assets were held long term.
  • Tax-deferred investments – Income from tax-exempt and tax-deferred vehicles like municipal bonds, tax-deferred non-qualified annuities, life insurance and non-qualified deferred compensation is not included in investment income.  It might make sense to consider rebalancing a portion of an investment portfolio before year-end to increase its municipal bond exposure.  Rebalancing may trigger capital gains but it may be advantageous to pay taxes on those gains now before the capital gain rate increases in 2013, absent Congressional action.
  • Installment sales – An installment sale is a type of sale whereby an asset is sold in exchange for a promissory note paid over a period of time.  Installment sales may be used to limit the amount of net investment income in any one year, as well as manage the taxpayer’s MAGI so as to avoid exceeding the income thresholds.
  • Life insurance – You may wish to incorporate life insurance as a non-correlated investment in your overall portfolio, as the cash surrender value inside a policy will continue to build up free from income tax and free from the Medicare surtax.
  • Qualified retirement plans – Maximize deductible contributions to 401(k)s, simplified employee pension plans, profit sharing plans, etc.  Business owners and professionals might want to consider defined benefit plans that may allow large deductible contributions.
  • Roth IRA conversions – Converting traditional IRAs to Roth IRAs prior to 2013 can reduce MAGI in 2013 and beyond, thereby reducing or eliminating surtax exposure.  If you convert in 2012 you would be taxed on the income arising from the conversion before the effective date of the Medicare surtax and likely higher ordinary income tax rates.  Also, distributions from Roth IRAs are not taken into account when analyzing the income thresholds, nor are the distributions considered net investment income.
  • Defer income over time to reduce your income each year below the MAGI threshold.  You may also want to defer losses and deductions until next year when tax rates are higher.
  •  Increase participation to make passive income non-passive to avoid the surtax. 

When considering the above strategies, it is important to determine whether or not they fit into your overall, long-term plan, factoring in both tax and non-tax implications.  Right now is an excellent time to get in touch with your tax and financial advisors to determine the best tax planning strategies to fit your individual facts and circumstances regarding the upcoming 3.8% Medicare surtax as well as the income tax rate changes that will go into effect in 2013, absent Congressional action.

If you have any questions regarding the 2013 income tax changes, or to learn more about the above tax planning strategies, we invite you to contact Stephen Valentine or Paul Bleeg at the San Francisco office of EisnerAmper at (415) 974-6000.


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