By: John Pitlosh CFP®, MST
Many affluent families have become resigned to the reality that the Bush Tax Cuts will expire at the end of this year and their tax bills will be going up. A lot of these same families might not be aware of the additional tax pinch they will be feeling in 2013 when a new set of taxes ushered in by the healthcare reform bill go into effect. While it might be impossible to avoid these new taxes altogether, it is important to know how they work, and minimize their impact on your bottom line.
When the Affordable Care Act became official back in March of 2010, the bills passage dried the ink on two new taxes that directly affect high income individuals making over $200,000 and married couples making over $250,000 on January 1st 2013.
Medicare Employee Payroll Booster Tax (0.9%) “ This additional 0.9% payroll booster tax gets added to the employees 1.45% of Medicare taxes that already comes out of their paycheck above the thresholds. For example, an individual making $290,000 will have $90,000 of wages subject to a total Medicare tax of 2.35%. In general, the withholding of payroll taxes isnt an area of concern to most employees because the responsibility for the withholding falls on the employer to implement. When the withholding is applied to an individual tax filer, the withholding is pretty straight forward. The only difference the individual will notice in the transition is that more taxes are being withheld.
When application of the payroll booster tax is applied to married couples, the withholding process is more complicated because the tax applies to joint wages above $250,000. For example, a married couple where each spouse is earning $195,000 and together they have a combined income of $390,000 would have employer withholdings of $0. In that situation, each spouses individual income falls below the $200,000 threshold, so the employer would not have any idea that an additional withholding on $140,000 would be necessary. As a result, the responsibility of the additional $1,260 of tax withholding will fall to the married couple. When 2013 rolls around, couples with dual incomes earning above the $250,000 will need to be aware of this issue.
Medicare Investment Income Surtax (3.8%) “ The headliner tax coming out of the health reform bill is the 3.8% surtax. The surtax will be applied to investment income of an individual, couple, or trust and estate above the $200,000, $250,000, and $11,200 level, respectively. While the income levels for the payroll booster tax are measured by earned income, the Medicare surtax is calculated using modified adjusted gross income (MAGI); for most people that will simply be the number on line 37 of their Form 1040.
Once you have established that your MAGI is over the threshold amount, the next step is to calculate the applicable net investment income to which the surtax will apply. Keep in mind that it cannot be reduced by itemized deductions. Net investment income includes the following types of income:
- Capital Gains
- Annuity Income
- Passive Activity Income
From a planning perspective, its also important to know where the surtax doesnt apply. For example, the surtax does not apply to the following income items:
- Wages or income from an active trade or business.
- Distributions from an IRA or other qualified retirement plan.
- Tax exempt interest from municipal bonds.
- Income generated inside a charitable remainder trus
Applying the facts of the Medicare Surtax
Lets take an individual with a $100,000 required minimum distribution who comes out of retirement to work part-time and makes another $90,000. If this individual also has a taxable investment portfolio that generates interest, dividends, and capital gains of $75,000, he will have a MAGI of $265,000. Because the threshold for an individual is $200,000, only $65,000 of the portfolio income will be subject to the 3.8% surtax.
Trusts and estates beware of the low thresholds
In the case of a trust or estate, the surtax applies to the undistributed net investment income or the excess of adjusted gross income of the trust or estate for amounts over the highest income tax bracket applicable to a trust or estate, i.e. $11,200. Because the surtax applies to such a low threshold in a trust or estate, trustees need to be cognizant of this issue and they should make an extra effort to distribute income out to beneficiaries or reallocate the trust assets to minimize the impact of the surtax.
Minimizing the impact through sound planning
Unfortunately, there is no magic bullet for affluent people that find themselves in the crosshairs of the surtax, but you can minimize the impact by structuring your income with a long term approach. Some simple remedies include taking advantage of the following:
Tax Free Municipal Bonds – Even though state and municipal budgets may be sketchy, general obligations have a very low default rate and their interest has the potential of being state, federal, and surtax free. In addition, the interest from municipal bonds doesnt get hit with the surtax and it doesnt get added to the individuas MAGI.
Contribute to Qualified Plans – Not that anyone really needs another reason to contribute to an IRA, 401(k), or pension, but the fact that qualified accounts are excluded from the surtax just adds to the list. Taking it one step further, the math for justifying Roth Conversions becomes more compelling as the conversion income and Roth IRA distributions are also excluded from the MAGI calculation for the surtax.
Charitable Remainder Trusts“ Investment income generated inside a charitable remainder trust is exempt from the surtax. The ability to contribute and sell highly appreciated assets inside a charitable remainder trust gives the contributor the ability to delay and even eliminate the surtax. If you factor in the possibility that future long-term capital gains rates will be going back to 20% along with the 3.8% surtax, the charitable remainder trust just becomes a more attractive tool for the charitably minded that is looking to efficiently structure a long term income stream.
It is inevitable that the future tax burden imposed on affluent individuals by health care reform and other deficit reducing measures is going to increase significantly in the years to come, but all is not lost. Through a long term approach and solid planning it is possible to successfully reduce your future tax burden, but the key is to start working with your advisor now before the new taxes go into effect.