Looking ahead to the new Medicare taxes

Year-end tax planning is as uncertain today as it was in 2010. The stakes may be even higher, as we are headed toward a “fiscal cliff” that features major spending cuts in addition to the tax increases. Yet the economy might be in better shape to withstand such a shock than it was two years ago. Gridlock is a very real possibility this time around. Taxpayers need to focus on what the law is, not what it might be.

Broadly speaking, there are three different tax debates under way. The first is over the extension of the temporary payroll tax cut. Because of the impact that this may have on the solvency of the Social Security trust fund, the support for extending this provision is weak. The second is over the “Bush tax cuts” of 2001 and 2003, which Democrats would continue for all but the “rich” and Republicans would make permanent for everyone. Finally, new Medicare taxes kick in beginning in January 2013. These will be changed only in the context of reform or repeal of the Affordable Care Act, which certainly can’t happen in a lame-duck session of Congress. Accordingly, higher-income taxpayers should plan with the assumption that these will go into effect.

Unearned income. For the first time, a 3.8% “unearned income Medicare contribution” will be imposed. This surtax applies to “net investment income” (NII) and also to capital gains from the sale of property. However, the surtax is limited to the lesser of NII or modified adjusted gross income (MAGI) above:

• $250,000 for marrieds filing jointly or surviving spouses;

• $125,000 for marrieds filing separately;

• $200,000 for singles and heads of households; or

• $11,950 (estimated) for estates and trusts

For purposes of this tax, long-term capital gains are taxed at the same rate as short-term gains.

Example 1. A single taxpayer has MAGI of $220,000 and investment income of $15,000. Because she is above the threshold, the 3.8% surtax applies to the full amount of the investment income, $15,000.

Example 2. A single taxpayer with MAGI of $85,000 has investment income and net capital gains of $100,000. No surtax is due, as the total income is less than the threshold.

Example 3. An income spike may push a taxpayer into the surtax zone. Add to Example 2 the fact that the taxpayer converted a $50,000 IRA to a Roth IRA in 2013. That would push MAGI to $135,000, so the 3.8% tax would apply to the $35,000—the amount of NII in excess of the $200,000 threshold.

Example 4. A trust has AGI of $25,000 and undistributed NII of $6,000. The Medicare surtax applies to the entire NII. Should the NII be distributed to beneficiaries, it is possible that they will not have to pay the tax, as the caps are so much greater for individuals.

Exclusions. The 3.8% Medicare Contribution Tax does not apply to charitable trusts, distributions from qualified retirement plans and IRAs, veteran’s benefits, interest on tax-exempt bonds, or the excluded gain on the sale of a principal residence. However, the excess gain on the sale of a residence can push a taxpayer into the taxable zone.

Strategies. Taxpayers who have been considering converting an IRA to a Roth IRA should look at making the conversion in 2012 rather than 2013. Although the conversion isn’t subject to the surtax, it is possible that it will trigger the tax on other investment income. A sale of appreciated assets might also be accelerated to avoid the future taxation.

Additional Medicare tax. A 0.9% additional Medicare tax applies to wages and self-employment income. The added tax applies to wages above $200,000 ($250,000 for marrieds filing jointly, $125,000 for marrieds filing separately). Note that for couples, the tax is imposed upon the combined wages of husband and wife.

Example 5. Wife has self-employment income of $180,000, and husband has wages of $120,000. If they were not married, neither would owe the additional Medicare tax. Because they are married, the tax is due on $50,000, the excess over the threshold. If they file separately, wife would owe the tax on $55,000.

Strategies. Usually, taxpayers try to defer income and accelerate deductions in their year-end strategizing. This year, accelerating bonuses and other income into 2012 may make more tax sense.

(November 2012)