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.