Planning for the New 3.8% Medicare Tax on Net Investment Income

Last week’s article reviewed in detail how the 3.8% Medicare tax on net investment income (NII) is calculated.  The new tax was enacted as part of the Patient Protection and Affordable Care Act and applies to certain “high income” taxpayers in tax years beginning after 2012.  This article presents a checklist of planning ideas that can reduce the amount of this tax on your NII.  Space does not permit a discussion of these ideas.  Therefore, be sure to consult your tax advisor before implementation.

In order to reduce the impact of the Medicare tax on NII, you must manage modified adjusted gross income (MAGI) and/or NII.  The following ideas reduce either MAGI, NII, or both.

1.     Close the sale of your business in 2012

2.     Diversify out of concentrated stock positions in 2012

3.     Close the sale of your second home, or the sale of your principal residence having gain in excess of the exclusion amounts, in 2012

4.     Accelerate investment income into 2012

5.     Convert a traditional IRA to a Roth IRA in 2012

6.     Exercise stock options in 2012

7.     Plan how to use the tax installment sale method:

a.      Elect out of the method for 2012 sales

b.     Use the method for post-2012 sales

8.     Don’t defer the first required minimum distribution from your retirement plan to April 1, 2013 if you attain age 70 ½ in 2012

9.     Use a November 30, 2012 fiscal tax year for the estate income tax return of recent decedents, and make the election to treat a qualified revocable trust as part of the estate income tax return

10.  Distribute NII of trusts and estates to beneficiaries

a.      Elect to treat distributions made during the first 65 days of 2013 as having been made on the last day of 2012

11.  Maximize deductible contributions to retirement plans

12.  Form family limited partnerships or limited liability companies to split income

13.  Use a non-grantor charitable lead trust for making charitable donations

14.  Defer compensation until retirement when your MAGI is lower

15.  Minimize sources of investment income by:

a.      Investing taxable account funds in tax-exempt bonds,

b.     Investing taxable account funds in low-yield, appreciating securities,

c.      Investing taxable account funds in tax-managed funds or accounts,

d.     Allocating retirement fund assets to tax-inefficient investments, such as higher yielding securities and funds or accounts with higher turnover ratios

16.  Use a charitable remainder trust for the sale of appreciated property

17.  Make investments in nonqualified annuities to defer investment earnings until retirement when your MAGI is lower

18.  Time capital gains to low-income years

19.  Make investments in cash value life insurance to fund future tax-exempt cash flow

20.  Harvest capital losses

21.  Increase the number of hours you work in a pass-through entity business that you own to avoid passive activity income

22.  Meet the tax definition of a real estate professional to exclude rental income from NII

23.  Use the like-kind exchange rules to defer gain recognition on the sale of business or investment property 

A couple of examples illustrate how advance planning with a Roth IRA can reduce the cost of the Medicare tax on NII. 

Example 1:  Larry is single and has $40,000 of NII and $190,000 of MAGI.  He withdraws $30,000 from his traditional IRA.  Although the IRA distribution is not NII, it does increase MAGI to exceed the $200,000 threshold for a single filer.  Therefore $20,000 of NII is subject to the 3.8% Medicare tax because of the distribution. 

Example 2:  Assume the same facts as above, except now the $30,000 withdrawal comes from his Roth IRA.  Again, the IRA distribution is not NII, but in addition, a qualified Roth IRA distribution is tax exempt and does not increase MAGI.  Therefore, none of Larry’s NII is subject to the 3.8% Medicare tax.  Ideally, if Larry had both a traditional and a Roth IRA, $10,000 would come from his traditional IRA and $20,000 from his Roth IRA.

Understanding the New 3.8% Medicare Tax

A new 3.8% Medicare tax is imposed on net investment income of certain taxpayers for tax years beginning after 2012.  The Medicare tax has historically only applied to earned income.  The new tax is part of Pres. Obama's "Patient Protection and Affordable Care Act."  The new tax will be assessed as part of the income tax returns of individuals, trusts, and estates.  The tax is 3.8% of the lesser of:

1.     Net investment income (NII) or

2.     The excess of modified adjusted gross income (MAGI) over the following threshold amounts:

a.      $250,000 for joint filers

b.     $125,000 for married filing separately

c.      $200,000 for individual filers

d.     $12,000 as estimated for trusts and estates (the start of the top income tax bracket as indexed for inflation)

Before defining the above terminology in detail, several observations are worth noting about the new tax:

1.     Only 3% of taxpayers have MAGI over $250,000, so this is really a tax on Pres. Obama's so-called "wealthy."

2.     The thresholds are not indexed for inflation, so over time more people will become subject to the tax.

3.     The threshold for married persons is not double the amount for single persons.  This increases the cost of the so-called marriage penalty.

4.     Coupled with the sunset of the Bush-era tax cuts, the top federal tax rate in 2013 will be 43.4% on ordinary investment income and 23.8% on long-term capital gains.  By contrast, the top tax rates in 2012 are 35.0% and 15.0% respectively.

5.     Trusts and estates can avoid the 3.8% tax by distributing the NII to beneficiaries.  The beneficiaries in turn would include the distributed NII in their calculation of the tax.  But a distribution for tax purposes might not be in accordance with goals of the trust or estate plan.

6.     Charitable remainder trusts are exempt from this tax.

7.     MAGI cannot be reduced with itemized deductions or personal exemptions because these deductions are taken after the calculation of MAGI.

8.     Investment expenses are typically claimed as itemized deductions which, while reducing NII, don't reduce MAGI.

9.     The tax is imposed on the full amount of NII only if MAGI exceeds the threshold amounts by at least the amount of NII.

10.  Estimated tax payments may be necessary to avoid an underpayment penalty.

NII equals investment income minus investment expenses.  MAGI equals AGI (the figure at the bottom of page 1, Form 1040) plus any foreign earned income and housing cost exclusions.

Investment income includes the following:

1.     Dividends and taxable interest income

2.     Short- or long-term capital gains (with certain exceptions)

3.     Royalties and the taxable portion of annuity payments

4.     Passive activity income which includes

a.      Rent net income

b.     K-1 income from partnerships, limited liability companies, and S corporations in which you do not materially participate.  Material participation generally requires working more than 500 hours in the business during the year.

5.     Income earned from the investment of business working capital allocable to K-1s.

6.     Hedge fund income

7.     Gain on the sale of a principal residence above the $250,000 (single) or $500,000 (joint) exclusion amounts

Investment income does NOT include:

1.     Wages and self-employment income (already subject to Medicare tax)

2.     Tax-exempt municipal bond interest

3.     Traditional IRA and qualified retirement plan distributions

4.     Roth IRA distributions

5.     Qualified annuity Section 403 plan distributions

6.     Deferred compensation Section 457 plan distributions

7.     Social Security and alimony income

8.     Gain on the sale of nonpassive business ownership interests, except to the extent the business holds investment property

9.     K-1 business income from partnerships, limited liability companies, and S corporations in which you materially participate

10.  The amount of gain excluded on the sale of a principal residence

A couple of examples illustrate how the tax is calculated.  My next blog article will discuss tax-reduction planning strategies.

Example 1:  Joe is a single individual with MAGI of $240,000, consisting of wages of $190,000 and NII of $50,000.  The new 3.8% Medicare tax applies to only $40,000 of his NII because his MAGI only exceeded the threshold by this amount.  His total tax increase is $1,520.

Example 2:  Joe and his wife earn $200,000 of wages, have K-1 income of $150,000 from an LLC in which they materially participate, and have $60,000 of investment income and $10,000 of investment expenses.  Their MAGI equals $410,000 and NII equals $50,000.  The new 3.8% Medicare tax applies to all $50,000 of NII and increases their tax by $1,900.

U.S. Supreme Court Upholds Affordable Care Act

The U.S. Supreme Court upheld the constitutionality of the Patient Protection and Affordable Care Act in a ruling issued June 28, 2012.  The ruling consisted of three primary components:

1. The Court allowed the mandate that requires individuals to purchase health insurance or else pay a penalty (beginning in 2014).  The Court concluded that the penalty could reasonably be considered a tax and that Congress has the power to impose taxes.  However, in order to be able to rule on this issue, the Court first had to determine that the penalty was not a tax because the Anti-Injunction Act prohibits a court challenge of a tax before it is paid.  The mandate first applies to 2014 tax returns filed in 2015.  The Court reasoned that since Congress never called the required payment a tax, but rather a "shared responsibility payment" (or penalty), that it wasn't a tax for this purpose.  Therefore the Court could proceed with a decision.  Then 18 pages later, the Court called the payment a tax in order to uphold the law!
2. The Court limited the Commerce Clause of the Constitution stating that Congress could not regulate economic inactivity, like a decision not to purchase health insurance.  This holding would have invalidated the law except for the tortured reasoning above.
3. The Court restricted Federal power to punish States choosing to opt out of expanding Medicaid, ruling that the Federal government could not cut off Federal funding of current Medicaid programs.  Only new Federal funding of the expanded Medicaid program could be withheld from non-participating States.

Chief Justice Roberts, who wrote the majority opinion, added this observation at the end of his opinion:  "But the Court does not express any opinion on the wisdom of the Affordable Care Act.  Under the Constitution, that judgment is reserved to the people."  The opposing political parties will be taking their cases to the American people, as national elections are on November 6, 2012.

Now that the Supreme Court has ruled, it is time to get serious about the implications of the looming tax increases and administrative burdens on individuals and businesses.  Future blog posts will examine these taxes and responsibilities, and suggest planning ideas for coping with the Affordable Care Act.