Coping with the New 3.8% Medicare Surtax

Beginning in 2013, a new 3.8% Medicare surtax will apply to investment income received by certain high-income taxpayers. The tax law provision authorizing this surtax was included in the Patient Protection and Affordable Care Act of 2010 recently upheld by the U.S. Supreme Court.

Here’s how it works: Based on a tax return calculation, a 3.8% surtax applies to the lesser of (1) your net investment income or (2) the amount by which modified adjusted gross income (MAGI) exceeds an annual threshold of $200,000 for single filers and $250,000 for couples filing jointly. The surtax is also imposed on trusts and estates with income above the threshold based on the dollar amount of the highest tax bracket.

For this purpose, “net investment income” includes interest and dividends; distributions from annuities (other than tax-deferred distributions); rent and royalties; gains from investments in passive activities; trades of financial instruments and commodities; and net capital gain from the sale of property (other than property held in an active trade or business). Significantly, it does not include salary or wages; distributions from IRAs and qualified retirement plans; taxable Social Security income; active trade or business income; self-employment income; gain on the sale of active interests in a partnership, S corporation or limited liability company; income from tax-exempt municipal bonds; and tax-deferred income from nonqualified annuities.

For instance, suppose that a couple filing a joint return realizes net investment income of $100,000 and has a MAGI of $300,000 in 2013. Because the $50,000 excess above the MAGI level is lower than the $100,000 of net investment income, the couple owes a surtax of $1,900 (3.8% of $50,000), on top of their regular income tax liability. However, for a couple with the same net investment income of $100,000 and a MAGI of $500,000, the surtax is $3,800 (3.8% of $100,000).

The 3.8% Medicare surtax in 2013 creates an added tax incentive to realize certain income before the end of this year. Here are several potential year-end strategies for investors to consider:

• You might arrange to sell assets that would produce long-term capital gain, such as securities, in 2012. Under current law, the maximum tax rate on net long-term gain is 15% (0% for certain lower-income investors), while the tax rate is scheduled to increase to 20% (10% for lower-income investors). Even if the lower capital gain rates are extended through 2013, you may be able to reduce or eliminate a surtax triggered by capital gains.
• If you’re selling real estate on an installment basis, you can avoid tax on at least a portion of the gain by completing the sale and receiving partial payment in 2012. Have your tax adviser account for the impact of the surtax when you structure the sale. If the circumstances dictate it, you can elect to report the entire taxable gain from an installment sale in the year of the sale.
• Consider investments in tax-free municipal bonds. Note that municipal bond income does not count as net investment income for purposes of the 3.8% Medicare surtax.
• If you plan to convert assets in a traditional IRA to a Roth IRA, it may make sense to convert in 2012 instead of waiting until 2013. This may effectively reduce the overall tax owed on the conversion. If you arrange a series of conversions, you might stagger them over several tax years to minimize the impact of the surtax.
• When it is otherwise advantageous, establish a charitable remainder trust (CRT). Typically, you will receive annual income from the CRT over its term, thereby spreading out the tax liability and exposure to the surtax. The remainder goes to a designated charity at the end of the trust term.

Final words: These are only a few of the ideas that may be considered in view of your personal circumstances. The tax law is ever-changing, so obtain professional assistance with respect to year-end planning.