Last year’s (2012) 5-4 Supreme Court ruling left the Patient Protection and Affordable Care Act (PPACA) intact and questions have been swirling on everything as to how the chronically uninsured will receive insurance, and how some small businesses will be compelled to wade through a sea of new rules and regulations.
Moreover, high-income earners and investors are also asking questions, since they will likely be forced to grapple with a new set of taxes. One major source of new revenues that will be imposed by PPACA, is centered around three new Medicare taxes.
The Net Investment Income Tax: A 3.8% surtax on unearned income.
The Additional Medicare Tax: An additional 0.9% Medicare tax that will be levied on wages.
Net Investment Income Tax: A 3.8% surtax on unearned income that took effect on January 1, 2013.
The tax will be applied against the lesser of the taxpayer’s net investment income or modified adjusted gross income (MAGI) in excess of the threshold amounts. Keep in mind that the 3.8% surtax is in addition to ordinary income tax and any alternative minimum tax.
Income Subject to Surtax
Let’s look at which types of income are subject to the tax and which are not.
Unearned income will be subject to the tax. This includes gross income from:
- Taxable interest
- Dividends
- Rent
- Taxable annuities
- Royalties
- Net Capital gains
- Passive activity – income from businesses in which the taxpayer does not actively participate.
- The net gain from property held for investment, including taxable portion of a gain from selling a personal residence that is above the $500,000/$250,000 exclusion.
Examples
- Tom is single, earns $120,000, and has dividends and capital gains of $40,000. His MAGI of $160,000 is below the threshold of $200,000. Tom avoids the 3.8% surtax.
- Noah and Tina, married filing jointly have wages of $240,000 and net investment income of $40,000 (MAGI of $280,000). The 3.8% surtax applies to $30,000.
Strategies to Consider
- Bulk up on tax-exempt interest. Consider tax-exempt municipals in lieu of other income-producing securities.
- Increase contributions to tax-deferred retirement plans. Maximize the contributions to IRAs, 401(k)s, or 403(b)s. Consider setting up a SEP-IRA if you are self employed which has more beneficial contribution limits.
- Defer taxes. Whenever possible, place investments that generate unearned income into tax-deferred accounts.
- Factor in retirement withdrawals. Qualified withdrawals from a Roth IRA are not included in MAGI and would not risk exposing investment income to the surtax. Consider converting a traditional IRA into a Roth. Be aware that the Roth conversion is a taxable event which will add to MAGI, and will possibly increase your exposure to the surtax.
- Time the income. Can you spread out income payments over several years, minimizing or eliminating the impact of the tax.
- Consider installment sales. Installment sales could defer income over several years and keep the seller under the MAGI limit or minimize the surtax.
- Use College Savings accounts. Save for education using Section 529 plans and Coverdell Education Savings Accounts.
- Make greater use of charitable trusts. Consider charitable remainder trusts to defer recognition of income, and non-grantor charitable lead trusts that shift income away from the grantor to the trust.
The new maze of complexity will create an extra level of frustration for many high-income investors. It’s unlikely the levies can be completely avoided, but with prudent planning, you can face the 2013 tax season armed with knowledge that eliminates unwanted surprises.
For additional information and before making any final decisions, please consult a tax advisor.
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