Medicare Surtax Planning

By Anthony D. Criscuolo and Melinda Kibler - Author's Blog Nov 8, 2013, 7:01 AM 

The end of 2013 is in sight. Most of us want to concentrate on holiday plans, travel and family. Tax planning is far down on the list.

Yet 2013 brings new tax regulations, and some year-end planning can alleviate future tax pain – which is an excellent holiday present to yourself.

Beginning with the 2013 tax year, a new Medicare surtax will apply to taxpayers who have net investment income (NII) and whose modified adjusted gross income (MAGI) exceeds a certain threshold. This new surtax will essentially raise the marginal income tax rate for affected taxpayers and is entirely separate from the regular income tax and alternative minimum tax. While it is called a “Medicare” surtax, the new tax actually goes toward the general revenue fund of the United States, not specifically to Medicare. The tax is often referred to as the net investment income tax (NIIT).

For individuals, trusts and estates, the surtax is a flat 3.8 percent tax imposed on the lesser of either net investment income or the excess of modified adjusted gross income for the taxable year over the threshold amount. If MAGI does not exceed the threshold amount, the net investment income will not be subject to the new tax.

The IRS defines net investment income as the sum of three “buckets” of gross income, reduced by allowable deductions. The first bucket is gross income from interest, dividends, annuities, royalties and rents (other than those derived in the ordinary course of business or those that are earned passively). Passive activity income, as defined by the IRS, makes up the second bucket. The third bucket comprises net capital gains derived from the disposition of property. Note that net investment income specifically excludes:

  • Income from an active trade or business
  • IRA or qualified plan distributions
  • Income from self-employment
  • Gain from the sale of an active interest in a partnership or S corporation
  • Any amounts exempt from income under income tax law (such as tax-exempt bonds or veteran benefits)

Certain expenses can be taken as deductions to reduce your investment income; thus the term net investment income. Deductions include investment interest expenses, margin expenses, investment counsel and advisory fees, state income taxes allocable to your NII, attorney or accounting fees, and depreciation or amortization deductions. To be deductible, these expenses need to be related to the production of your investment income. The expenses are subject to the same limitations applied to itemized deductions as reported on your Schedule A (such as the 2 percent floor for certain miscellaneous itemized deductions and the overall limitation on itemized deductions for high-income taxpayers, also known as the Pease limitation).

The three different “buckets” of gross income are an important concept in understanding the NIIT. For example, capital losses work slightly differently under the surtax regulations than they do for regular income tax. This is because the net capital gain calculated for net investment income purposes (part of the third bucket of NII) may not be less than zero. Therefore, capital losses may only offset capital gains, not other forms of investment income such as interest or dividends. Nor may you use the up to $3,000 of excess capital losses that are generally allowed to offset other ordinary income for regular income tax purposes.

For example, assume a taxpayer’s only two sources of income were $300,000 of interest and a net capital loss of $250,000. For regular income tax purposes, you are allowed to use $3,000 of the net loss to offset other income, resulting in gross income of $297,000. The remaining capital loss of $247,000 is carried forward to future tax years. However, for purposes of calculating your NII, the capital loss (part of bucket three) may not offset any of the interest income (bucket one). This means, in our example, the taxpayer’s total NII will be the full $300,000 of interest. An easy rule to remember is that investment income may only be offset by losses from other investments within the same bucket.

Modified adjusted gross income, for purposes of calculating the NIIT, is defined as a taxpayer’s adjusted gross income modified by adding the net foreign earned income exclusion. For many taxpayers, this will be the same as their adjusted gross income.

The threshold amount for the surtax depends on your filing status. The amounts are as follows:

  • Single, head of household (with qualifying person), or qualifying widow(er) with a dependent child: $200,000
  • Married filing jointly: $250,000
  • Married filing separately: $125,000
  • Estates and trusts: based on the top tax bracket for the taxable year ($11,950 in 2013)

The threshold amount is the key factor in determining the “lesser of” formula for the purposes of calculating the surtax. Also note that this surtax is charged in addition to the regular federal income tax (and alternative minimum tax), effectively raising the marginal income tax rate for affected taxpayers.

All of this may seem overwhelming. The following examples will help you see how calculating the surtax works in practice.

Example 1: Charlie, a single taxpayer, has $100,000 of salary and $50,000 of net investment income. His MAGI totals $150,000. Because his MAGI is less than the $200,000 threshold, the surtax will not apply.

Example 2: Abigail is also a single taxpayer. She has $225,000 of net investment income, and no other income sources. Since she has passed the MAGI threshold, she owes the 3.8 percent surtax on the lesser of her net investment income or the amount by which her MAGI exceeds the threshold. In this case, she will owe the tax on $25,000, the difference between MAGI and the threshold, as it is less than the entirety of her net investment income.

Example 3: Randy, a single taxpayer, is 69 years old. His net investment income is $200,000, so he is not subject to the surtax. However, next year he will have the same investment income and an additional required minimum distribution from his IRA, totaling $125,000. This pushes his MAGI up to $325,000, though the IRA distribution does not affect his total net investment income. Since Randy’s MAGI exceeds the threshold, he will have to pay the surtax. In this case, he will owe tax on the amount the MAGI exceeds the threshold, $125,000, which is less than his total net investment income ($200,000).

Planning Strategies for the NIIT

Now that you have a basic idea of how the surtax works, we can turn to planning strategies to lessen the burden of the new tax. There are two main approaches to minimize the impact of the surtax. The first is to reduce your net investment income and the second is to reduce your MAGI.

There are a variety of tactics you could adopt to accomplish the first goal. Here are some ideas, a few of which we will cover in more depth:

  • Municipal bonds
  • Tax-deferred annuities
  • Life insurance with cash value
  • Rental real estate
  • Oil and gas investments
  • Choice of accounting year for an estate or trust
  • Timing of estate or trust distributions

Municipal Bonds
In determining if a municipal bond is preferable to a corporate bond, one must calculate the after-tax rate of return. Income from a corporate bond would be subject to both income tax and the net investment income surtax for a taxpayer whose MAGI exceeds the NIIT’s threshold. A municipal bond would not be subject to income tax, nor would it be subject to the new surtax, regardless of the taxpayer’s MAGI. Additionally, income from a municipal bond would not be included in MAGI either, so the municipal bond will help an investor stay below the threshold amount. Generally speaking, as tax rates go up (or new taxes are imposed), the after-tax yield of taxable bonds goes down, thus making municipal bonds more attractive.

Life Insurance with Cash Value
Whole and universal life insurance policies often include an investment component in addition to the death benefit. This is generally referred to as the policy’s cash value. All gains inside the life insurance policy are tax-deferred, and thus are not included in your MAGI and NII calculations.

Consider this example: Joe, a married-filing-jointly taxpayer, paid a one-time, $250,000 premium to purchase a $2.5 million universal life insurance policy. Ten years later, Joe withdrew $40,000 from the policy, when its cash value was $400,000 ($150,000 more than Joe paid originally). Until Joe withdraws more than his initial premium, none of the policy’s earnings will be subject to the NIIT.

Obviously, a given policy’s fees and investment options will affect its attractiveness as an investment, but its tax-deferred nature makes it more desirable in a higher tax-rate environment.

Tax Shelter Investments
In general, certain investments offering non-cash deductions (such as in oil and gas investments and rental real estate) are helpful as tax shelters, and their importance will increase for those looking to minimize or eliminate their surtax obligations. Oil and gas investments often provide intangible drilling costs deductions and rental real estate has depreciation deductions, both of which reduce your NII. It is important to stress however, that one should not allow the increased tax rates to completely control the investment process. Tax efficiency should be just one of many factors you examine when selecting an investment and evaluating its merits within the context of your overall financial plan and asset allocation.

Planning for Trusts and Estates
The NIIT can hit trusts and estates particularly hard because of the low threshold amount ($11,950 in 2013). In order to reduce the tax, fiduciaries may want to consider making distributions of the trust or estate’s net investment income. Because trusts and estates receive an income distribution deduction, the income is ultimately reported by the beneficiary, and any resulting NIIT will be based on the beneficiary’s personal income tax return. Assuming that a trust or estate has beneficiaries who are not subject to the NIIT, the choice to make distributions from the trust or estate can help to minimize the overall tax burden. This strategy may not be practical, however, if the trustee or grantor did not intend for the beneficiaries to receive distributions.

One other possible solution is to create multiple trusts, or to divide a current trust into multiple trusts. Each new trust will have its own threshold amount, essentially spreading the investment income from one big trust to numerous smaller trusts. As long as the undistributed NII of each trust is below the threshold, this strategy could allow a trust to avoid the NIIT completely. Note you have to have a legitimate reason for dividing a trust, such as maintaining separate trusts for multiple beneficiaries with different investment goals or setting up trusts for different primary objectives (such as education or health). Tax avoidance is not a legitimate purpose on its own. You must also consider the additional costs associated with maintaining multiple trusts, including tax preparation fees, annual accounting fees and trustee fees, when deciding whether this strategy makes sense in your situation.

Besides reducing net investment income, the other main approach for tax planning related to the new surtax is to take steps to reduce your MAGI to less than your applicable threshold amount. There are also a variety of strategies that can help you achieve this goal, including the following:

  • Roth IRA Conversion
  • Charitable Remainder Trust
  • Charitable Lead Trust
  • Installment Sales
  • Gifts

Roth IRA Conversion
Depending on your time horizon and your overall tax situation, you may want to consider a Roth IRA conversion. Converting a traditional IRA to a Roth IRA should lower your overall taxable income in the long term. In addition, Roth IRAs do not have required minimum distributions and withdrawals for beneficiaries are tax-free. If the conversion would push your income above the threshold, consider converting over the span of several years instead. To employ this strategy effectively, it is ideal to use funds from outside the IRA to cover the income tax liability created in the year, or years, of conversion.

Charitable Trusts
If you have philanthropic intentions, you might also consider a Charitable Remainder Trust (CRT) or a Charitable Lead Trust (CLT). Our colleague Eric Meermann outlined the basic structures of each trust in his article “Creative Approaches to Charitable Giving.” The trust would reduce your MAGI while, at the same time, allowing you to meet your charitable objectives.

Installment Sales
Another strategy to reduce MAGI is to structure certain dispositions of property as installment sales. An installment sale is one in which the seller exchanges an asset for a promissory note, paid over a period of time; thus the taxable gain that the seller recognizes will be partly deferred. By spreading the income over a longer period, the seller can prevent a spike in income after selling a highly appreciated asset, which would otherwise push their MAGI over the threshold in the year the sale takes place.

Depending on your goals, you can also reduce MAGI through an outright gift. Giving assets that produce significant investment income to recipients with lower MAGI can keep you, and ideally the gift recipient, below the surtax threshold. However, there are a few caveats to keep in mind when deciding whether to give for this reason. First, one must be comfortable relinquishing control over the asset. Second, under the so-called “kiddie tax” rules, the unearned income of young children may subject their income to their parents’ tax rate, including the new surtax. A gift needs to be planned carefully if one of the intentions is reducing the burden of the NIIT.

Even with these strategies for reducing MAGI and net investment income, you may still find yourself subject to the surtax. If this is the case, it is important to note that the surtax is subject to the estimated tax provisions. Therefore, you should promptly confirm whether the surtax applies and, if so, you should pay your estimated tax or adjust your withholdings as soon as possible to avoid underpayment penalties. Because net investment income can vary greatly from year to year, many taxpayers may prefer to rely on the safe-harbor rules for estimated payments. These rules require that you pay 100 percent (or 110 percent, for high-income taxpayers) of your prior year’s tax liability.

At this time, the IRS is still considering some of the issues related to the NIIT, but the Service has stated that taxpayers can rely on the proposed regulations until final regulations are issued. For now, it makes sense to plan for the new tax based on the proposed regulations.

While this new Medicare surtax may seem complicated, the overall planning strategies are relatively simple: reduce net investment income, reduce MAGI, or both. The best way to go about these measures will depend on your individual situation, but planning ahead will allow you a happier start to 2014, especially when your tax bill comes due in April.

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