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Understanding and Planning for the New Health Care Surtax

Posted by McDonald & Osborne Posted on Oct 13 2015

On January 1, 2013, the 3.8% Medicare surtax, passed by Congress in 2010 to help pay for healthcare reform, goes into effect. In order to help taxpayers plan for the surtax, we have summarized what type of income the tax applies to and how it is calculated. We have also listed a few ideas on how to reduce this tax if you find it applies to your situation.

The Medicare surtax applies to individuals, and trusts and estates if certain thresholds are met. For individuals, the surtax is assessed on the lesser of the Net Investment Income or the excess of Modified Adjusted Gross Income over the statutory threshold amount for that year. For taxable trusts and estates, the surtax applies to the lesser of the Undistributed Net Investment Income for the tax year or the excess of the estate or trust’s Adjusted Gross Income above the threshold amount.

For purposes of calculating this tax, net investment income is defined as interest, dividends, capital gains, annuities, rents, royalties, unless derived in the ordinary course of a trade or business, and passive activity income reduced by any allowable related deductions.

Types of income that are excluded from net investment income are self-employment income, active trade or business income, gain on the sale of an interest in a partnership or S corporation that is not a passive activity, and distributions from IRAs or other qualified retirement plans.

For individuals, modified adjusted gross income is the amount reported at the bottom of page 1 of Form 1040 (adjusted gross income) plus the net amount excluded as foreign earned income. Unless you are a U.S. citizen or resident living abroad, the foreign earned income exclusion does not apply to you so generally, your modified adjusted gross income and adjusted gross income will be the same amount.

The applicable threshold amounts vary depending on filing status and are as follows:

$250,000 for married taxpayers filing jointly

$125,000 for married taxpayers filing separately

$200,000 for all other individual taxpayers

$11,950 for trusts and estates

The strategies for minimizing exposure to the surtax involve reducing net investment income and reducing modified adjusted gross income. Bear in mind, it is important to balance your desire for tax planning with any long range wealth plans when considering these mitigation strategies.

A few of the approaches to reduce your net investment income or modified adjusted gross income are as follows:

Investing tax exempt bonds. The interest income from corporate bonds is includible in net investment income while interest on tax exempt bonds is not. However, keep in mind that the decision to switch from corporate to municipal bonds should be made only if you have considered the after-tax return on investment.

Using tax deferred annuities and life insurance. If you have net investment income and modified adjusted gross income above the threshold amount now but you expect to have much lower income in later years, this strategy could move net investment income to a time when your overall income will be below the threshold and as a result the net investment income will not produce any surtax.

Using Rental Real Estate Losses. While income from rental real estate is a passive activity and includible in net investment income, keep in mind that losses from such activity can also reduce overall net investment income.

Current contributions to qualified retirement plans reduce income. However, while later distributions from these plans are not considered net investment income they are included in the calculation of modified adjusted income.

Traditional IRAs. Deductible contributions to an IRA will lower your modified adjusted gross income; non-deductible contributions will not. IRA’s have required minimum distributions once you reach 70 ½. The required distributions are not includible as net investment income; however, they will increase modified adjusted gross income.

Roth Conversions. Converting a traditional IRA to a Roth IRA is a taxable event that is includible in modified adjusted gross income; however, distributions from a Roth are not taken into account when calculating net investment income nor are they included in modified adjusted gross income. Before doing a Roth conversion a comprehensive analysis of the cost/benefit should be done in order to achieve the better overall tax results.

Installment sales. Sales of assets on the installment basis can be used to limit the amount of net investment income in a year in addition to managing the modified adjusted gross income to keep it below the income thresholds. The classification of the asset sold determines whether the surtax applies to any gain.

Gifting of Assets. Outright gifts of investment income producing property to charity or individuals in a lower income bracket removes the asset from your possession and results in a reduction of income from that asset. Bear in mind that gifting of assets to individuals may trigger gift tax liability while gifts to charity may result in a charitable deduction for the donor.

Distributions to Beneficiaries. For taxable Trusts and Estates the adjusted gross income threshold for the surtax is low ($11,950.) This means that most net investment income of a trust or estate will be subject to the surtax unless it is distributed. If the trust beneficiaries will not be subject to the surtax on distributions on their individual returns, trustees should consider distributing enough of the net investment income to reduce undistributed net investment income below $11,950 thereby saving surtax at the trust level.

These are just a few of the approaches that may be used to help reduce or eliminate the applicability of the Medicare surtax. We recommend you consult your tax and financial planners prior to implementing any mitigation plan. If you have any additional questions relating to the applicability of the surtax or you wish to discuss planning options for your situation, please feel free to call us. We would be happy to assist with any planning needs you have.

Angela Krape, CPA

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