Avoiding the New Tax on Investments

The Supreme Court upheld the Patient Protection and Affordable Care Act of 2010 (a.k.a., Obamacare). As a result, among the provisions that will go into effect in 2013 are the expanded Medicare taxes on high income taxpayers.

Foremost among the new taxes is the 3.8% tax on the “unearned” income of single taxpayers with modified adjusted gross incomes exceeding $200,000 and married couples filing jointly with MAGIs above $250,000. The income thresholds aren’t indexed for inflation, so more people will owe them over the years. Though the tax is labeled a Medicare surtax, the proceeds actually will go into general revenues, not the Medicare fund.

The New Investment Surtax

MAGI for this tax is your regular AGI plus any foreign earned income that qualified for the exclusion from gross income.

The IRS hasn’t issued guidance on the tax yet, so there is some uncertainty over the specifics of the tax.

Unearned income for this tax is investment income and includes interest, dividends, capital gains, annuity distributions (taxable distributions only and only when not from a qualified retirement plan), royalties, and passive real estate rental income. Taxable distributions from master limited partnerships and real estate investment trusts aren’t named in the tax code but probably will count as unearned income.

Distributions and pass-through income from partnerships and S corporations are trickier. The likely final rule will be if the income is subject to the self-employment tax it probably isn’t unearned income for this tax. But if you are an owner who isn’t active in the business, the income probably will be subject to the tax.

Unearned income for the tax doesn’t include tax-free interest or distributions from qualified retirement plans, such as 401(k)s, traditional IRAs, Roth IRAs, profit-sharing plans, and defined benefit plans. Social Security benefits and life insurance payouts also aren’t subject to the tax.

The surtax is imposed on the lesser of net investment income and the amount of MAGI above the threshold. Suppose Max and Rosie Profits have investment income of $30,000 and MAGI of $270,000. Their net investment income is $30,000, and the excess of MAGI and the threshold is $20,000, so they pay the tax on $20,000. Multiplied by 3.8% brings a tax of $760. If everything else were the same except their MAGI were $290,000, they would owe tax on the net investment income. That tax would be 3.8% of $30,000, or $1,140.

If the 2012 tax rates are extended into 2013, the surtax will increase the maximum tax on long-term capital gains and qualified dividends to 18.8%. But if the Bush tax cuts are allowed to expire, the top long-term capital gains rate becomes 25%, and the top rate on qualified dividends rises to 44.6%.

One trick to this tax is that all sources of income increase your MAGI and potentially trigger the tax, but only the “unearned” income is subject to the tax. For example, you might take an additional IRA distribution in 2013 to pay medical expenses. IRA distributions aren’t subject to the surtax. But the distribution will increase your MAGI and could push you from an income level that is exempt from the surtax into one that pays the surtax on all your unearned income.

Home Sales and the Surtax

One question some have is how sales of homes will be treated. The expected treatment of gains from home sales is expected to work like this. The surtax will apply only to gains, not to the sale price. In addition, the exclusion of gains from the sale of a home should apply to the surtax just as it does to the capital gains tax. So, you shouldn’t have to worry about paying the surtax on the sale of your principal residence unless your gain exceeds $250,000 for a single person or $500,000 for a married couple filing jointly.

It looks like the gross proceeds of the sale of a principal residence shouldn’t increase your MAGI and trigger the Medicare surtax on your investment income. Only the net gains that exceed the exclusion amount should be included in MAGI.

Sales of second homes and rental properties, however, will be fully included in MAGI, and gains on the sales will be subject to the surtax. But if you qualify as a real estate professional, the gain might be exempt from the surtax. Confirmation of that awaits IRS guidance.

The larger issue, however, might be that a sale of a second home or rental property is likely to trigger the surtax on not only the gains from the property but also on all your other investment income that year.

Here are strategies to consider now and in the future to avoid paying the Medicare surtax on investment income.

Sell assets with large gains in 2012. If you’re likely to sell the assets in the next few years, you might want to sell by December 31, 2012. You’ll lock in the 15% maximum long-term capital gains rate, avoid the 3.8% Medicare surtax, and avoid triggering the surtax on other investment income. It’s a tough call, because you don’t want taxes alone to dictate investment decisions. The surtax, however, does increase the cost of holding assets for another year or two and might tip the scale toward selling sooner instead of later.

Business owners need to realize that the surtax will apply to the sale of your business. That’s an extra 3.8% in addition to the other taxes and the costs of selling. Those who were considering sales in the near future should consider the benefits of closing a deal by the end of 2012.

Tax-exempt bonds. When your income is high enough to trigger the surtax regularly, shifting some income investments to tax-exempt bonds instead of some other types could pay off. Tax-exempt bonds both lower your MAGI and avoid the surtax.

Convert to Roth IRAs. Distributions from traditional IRAs and pensions are exempt from the surtax, but distributions from them count in your MAGI and can trigger the surtax on your investment income. When retirement plan distributions combined with your other income are likely to trigger the surtax, you’ll save a lot of money long term by converting traditional IRAs to Roth IRAs. Roth IRA distributions are not included in MAGI. It’s a factor that could tip the balance in favor of converting IRAs if the benefits of a conversion were on the borderline before the new law.

Keep in mind, however, that in the year of conversion the amount converted will be included in your MAGI and could trigger the surtax on other investment income. So, carefully consider having conversions completed by the end of 2012. Review the article on page 3 of this visit.

Review deferred compensation strategies. A classic tax strategy is to defer income and taxes, especially on compensation. You might want to reconsider such strategies. Deferring compensation from 2012 to 2013 or later could trigger the surtax on investment income, because the deferred compensation will be included in your MAGI.

Boost retirement plans. Since distributions from qualified retirement plans are exempt from the surtax, upper income taxpayers with some control over their situations, such as small business owners, might want to make greater use of qualified plans. Creating a traditional defined benefit pension plan, for example, will increase tax deductions now and generate future income that is exempt from the surtax.

Don’t forget the other Medicare surtax in Obamacare. This is an additional 0.9% tax on wages, salaries, and self-employment income on top of the regular Medicare tax. (This tax does go to the Medicare trust fund.) It’s imposed on singles with total wages of more than $200,000 and married couples with more than $250,000. This tax will be withheld by your employer or be part of the self-employment tax. It won’t be separately listed on W-2s. This Medicare surtax is another reason to consider not deferring compensation past 2012.

RW August 2012.