Healthcare Practice Strategies – Fall 2012 — Year-end Tax Planning Strategies: Strategic Planning for the New Medicare Surtax

October 22, 2012

The challenges of tax planning for 2012 and 2013 have increased dramatically with the election year uncertainty in Washington. But regardless of whether the Bush-era tax cuts are extended beyond this year or not, many high-net-worth individuals will see a new 3.8 percent Medicare surtax come into play next year.

As part of the Affordable Care Act, this surtax will be imposed on the unearned income of many high-net-worth individuals beginning in 2013. Unearned income includes:

• Dividends
• Rents
• Interest
• Passive activity income
• Capital gains
• Annuities
• Royalties

The surtax is also imposed on estates and trusts, although slightly different rules apply (see sidebar below). For taxpayers, the amount subject to the Medicare surtax will be the lesser of:

1) Net investment income (NII), or

2) The amount of modified adjusted gross income (MAGI) over certain thresholds.

The MAGI threshold for married taxpayers filing jointly is $250,000, while it’s $125,000 for married taxpayers filing separately and $200,000 for individuals.

For example, Dr. and Mrs. Smith are married taxpayers filing jointly. They have $300,000 in income from salary and $100,000 of net investment income. The amount subject to the surtax would be the lesser of NII ($100,000) or the excess of their MAGI ($400,000) over the threshold amount ($400,000 -$250,000 = $150,000). Because NII is the smaller amount, the tax is calculated on this base, so the surtax would be $3,800 (.038 x $100,000).

AVOIDING OR MINIMIZING THE SURTAX

To avoid or minimize the adverse effects of the Medicare surtax, you may want to consider these investment vehicles to help keep your MAGI and/or NII below the thresholds:

• Tax-deferred or tax-free investments – Income from tax-exempt bonds and non-qualified annuities, for example, is not included in NII.
• Life insurance – Purchasing a whole life insurance policy allows you to reallocate money from assets that create current NII and/or MAGI to assets that create neither, and then withdraw basis from the policy in lower-income years. 
• Qualified retirement plans – Maximizing contributions to qualified retirement plans such as IRAs, 401(k)s, and 403(b) and 457 plans may make sense, as distributions from these retirement plans are not subject to the investment surtax.
• Roth IRA conversions – Converting traditional IRAs to Roth IRAs in 2012 rather than 2013 can reduce MAGI in 2013. 
• Rental real estate – If depreciation deductions on rental real estate exceed rental income, the net loss may be able to offset other investment income (limitations apply). 
• Oil and gas investments – Intangible drilling costs (IDCs) associated with investments in oil and gas wells can produce a large current deduction — as much as 80 percent of the amount invested.
• Installment sales – Installment sales in which an asset is sold in exchange for a promissory note paid over a period of time may be used to limit the amount of net investment income in any one year, as well as manage your MAGI.
• Above-the-line deductions – Deductible contributions to a Health Savings Account, self-employed retirement account and a traditional IRA could reduce exposure to the surtax.

Surtax Strategies for Trusts and Estates

Under the Supreme Court’s decision upholding the Affordable Care Act, trusts and estates will be subject to the 3.8 percent Medicare surtax on the lesser of undistributed net investment income for the taxable year, or the excess (if any) of adjusted gross income over a threshold amount.

Thus, a trust in the highest potential marginal tax bracket in 2013 (39.6 percent) will have a marginal rate of 43.4 percent.

Given the relatively low threshold amount (currently just $11,200), most net investment income of a trust or estate will be subject to the surtax unless it is distributed. If the beneficiaries would not be subject to the surtax on distributions, distributing enough of the net income to reduce undistributed income below $11,200 can help avoid the surtax.

Healthcare Practice Strategies – Fall 2012 Issue