Medicare surtax planning for high incomes

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Mike McDevitt

Mike McDevitt

As the year comes to a close, there’s little time left to be sure your investments are tax-smart. The Affordable Care Act, commonly known as Obamacare, creates additional Medicare taxes for high-income taxpayers. There are two new Medicare tax increases: (1) a 3.8 percent tax on “net investment income,” and (2) a 0.9 percent Medicare tax on earned income. Generally, if your income exceeds $200,000 (single filing), or $250,000 (joint filing), you are at risk for these new taxes.

Net investment tax

Beginning in 2013, higher-income individuals with “net investment income” will be subject to an additional 3.8 percent tax of the lesser of two amounts:

• Your “net investment income,” or

• The excess of the taxpayer’s modified adjusted gross income over a $200,000 (single) or $250,000 (joint filers) threshold amount.

Net investment income includes three broad categories:

• Interest, dividends, annuities, royalties, and rents;

• Income from a business in which the taxpayer does not personally, materially participate, and business income from trading and financial instruments or commodities;

• Capital gains and other net gains from the sale of property.

Exclusions: Most investment income categories are exempt if they are derived from a business activity in which the taxpayer materially participates. Any income subject to self-employment tax is excluded, as is tax-exempt interest income, retirement plan distributions, and tax-free gains from a principal residence. Also, S-Corporation profits are exempt.

Medicare surcharge tax

Currently, the Medicare tax applies to all wages and self-employment income. For wage earners, both the employer and the employee pay 1.45 percent, whereas a self-employed taxpayer pays the entire 2.9 percent.

Beginning in 2013, the health care legislation imposes an additional 0.9 percent surtax — but only on higher-income households. The tax applies to income in excess of a single person’s wage and self-employment income over $200,000, or a married couple’s combined income exceeding $250,000.

While both taxes only impact high income earners, the threshold focuses on total “modified adjusted gross income” in the tax return. On the other hand, the 0.9 percent Medicare surcharge focuses only on the wage and self-employment earned income. In both cases, the new taxes only apply to income in excess of the thresholds.

Net investment income tax planning

The more complex planning challenges come into play with the net investment income portion of the new tax. But with careful execution of a well-designed plan, there may be ways you can potentially reduce net investment income and, thus, the potential impact.

If your income is at or near these thresholds, the focus will be on maintaining a consistency in reportable income from year to year so as to stay beneath the thresholds. Spikes in income from large IRA withdrawals, bonuses, and substantial capital gain recognition can trigger these taxes.

Using an installment sale to shift a large capital gain from an investment into multiple tax years could help you stay beneath the threshold of the 3.8 percent tax. Similarly, a lump sum distribution from a retirement account could trigger the 3.8 percent tax, so consider taking payments out over a number of years.

An owner-occupied commercial building could utilize a strategy to manage the income in the rental entity by modifying rents paid by the business tenant. This strategy should take into consideration practical cash flow concerns of covering building expenses as well as ensuring the rent still represents a fair market value. Consult with your tax advisor to implement a strategy that benefits you while ensuring you are within the regulatory boundaries.

Another possible strategy would be to shift some investments with taxable earnings into municipal bonds and municipal bond funds, whose earnings are excluded from the MAGI and the net investment income calculation. They also provide a double potential benefit of not triggering the surtax on other investment income and are also excluded from the Medicare surtax. Alternatively, choose to hold investments that produce taxable interest or dividends in tax-deferred accounts like an IRA.

Medicare surtax planning

Be prepared. If you’re married, filing jointly and your combined wages will exceed $250,000, make sure your joint Medicare surtax isn’t significantly higher than anticipated.

Your employer won’t take your spouse’s income into consideration when figuring your Medicare tax withholding, so dual-income households that exceed the threshold are more likely to be under-withheld.

Reducing MAGI is difficult for those still working. One strategy: maximize contributions to pretax retirement plans like traditional 401(k)s or 403(b)s.

If you own an S-Corporation, consider whether the wages you pay yourself are too high for services rendered. You may consider reducing your wages and paying the difference in distributions. Be careful, though — if you need to maintain a high wage to justify large pretax retirement contributions, this strategy may backfire. Careful consultation with your tax expert is required.

All in all, a tax-smart investment plan is more important than ever. Talk to your tax adviser to help ensure your tax planning matches your investment and income needs.

Michael McDevitt, CPA, is director of tax for BiggsKofford, one of the largest locally owned CPA firms. He can be reached at