“You have to learn the rules of the game,” according to Einstein, “and then you have to play better than anyone else.”
A provision of this year’s health reform legislation imposes a new Medicare contribution tax on the net investment income of higher-income individuals, estates and trusts–beginning in 2013.
The tax is subject to federal estimated tax requirements.
Fortunately, the timeline provides you and your advisors with nearly three years to learn the new rules and to consider ways to minimize the tax impact.
Calculating the Tax
The Medicare contribution tax is 3.8 percent of net investment income and is in addition to any other taxes that may apply.
Individuals
The amount subject to tax is equal to your net investment income or, if less, the amount by which your modified adjusted gross income exceeds a threshold amount. This threshold is $200,000 per year for singles, $250,000 for married couples filing joint returns, and $125,000 for married couples filing separately. Modified adjusted gross income includes foreign earned income.
Estates and Trusts
The amount subject to tax is equal to the estate or trust’s undistributed net investment income or, if less, the amount by which adjusted gross income exceeds the beginning amount for the highest income tax bracket. This year, the beginning bracket amount is $11,200.
Definition of Net Investment Income
According to the Reconciliation Act’s Committee Report, net investment income subject to the Medicare contribution tax includes interest and dividends, annuities, rents and royalties, gross income from a trade or business involving either passive activities or the trade of financial instruments, and net gain from the disposition of certain nonbusiness property.
Generally, net investment income does not include tax-exempt bond interest, veteran’s benefits, qualified retirement distributions, excludable gain from the sale of a primary residence, income from a trade or business not involving passive activities or the trade of financial instruments, and certain gain from the disposition of a partnership interest or stock in an S corporation.
Planning Opportunities Based on Income Type
Many of the exclusions from net investment income provide opportunities to reduce the impact of the Medicare contribution tax.
Tax-exempt bond interest is not subject to the new tax. Depending on your overall investment strategy, you may be able to reduce your tax liability by shifting some or all of your investments to tax-exempt bonds.
Distributions from IRAs and other tax-advantaged retirement plans are not considered investment income subject to the new tax. If you’re not contributing the maximum allowable amount to your retirement account(s), it may be beneficial to move funds from your regular investments to your retirement account each year.
Also, while the distributions from these qualified retirement plans are not subject to the Medicare contribution tax, they are included in the calculation of modified adjusted gross income. The increased amount of modified adjusted gross income could result in an increase in the amount of your other investment income that is subject to tax. The same is true for the gross income resulting from the conversion of a traditional IRA to a Roth IRA.
With advance planning, you can reduce the impact of the new tax on income resulting from converting to a Roth IRA–and as another benefit, Roth distributions are not included in the calculation of modified adjusted gross income.
Depending on your age and other factors, you may also be able to reduce the impact of the new tax on required minimum distributions for at least one year.
Any gain on the sale of a principal residence that is excludable for income tax purposes is also exempt from the Medicare contribution tax. Under current income tax rules, the maximum excludable gain is $250,000–or $500,000 for married couples filing joint returns. If you plan to sell your principal residence after 2012 and anticipate a gain in excess of the excludable amount, you avoid the 3.8 percent tax on the excess gain simply by accelerating the sale of your home. Note that the gain exclusion does not apply to secondary residences or vacation homes.
If you receive income from a partnership, LLC or an S corporation, the income is subject to the Medicare contribution tax unless you materially participate in the activities of the trade or business. Material participation requires regular, continuous and substantial involvement.
Generally, gain from the disposition of a partnership interest or the stock in an S corporation is also subject to the Medicare contribution tax unless you materially participated in the activities of the trade or business. Under certain circumstances, the amount of the gain subject to tax may be limited.
Planning Opportunities Based on Timing of Income Recognition
The 2013 implementation date affords other planning opportunities in situations where you can accelerate recognition of income for tax purposes. For example, if you’re planning to sell a vacation home, or stock in a business, or any other investment as an installment sale, you can opt out of the installment sale treatment for tax purposes and recognize the income in a year before the new tax is implemented.
The tax and financial implications of any strategy to minimize the Medicare contribution tax are complex and can have unintended consequences that might outweight any reduction in the Medicare contribution tax. If you think the new tax may impact you, contact your advisor at Bader Martin to discuss your options.
