Now that the health care law has been declared constitutional, the remaining provisions will be going into effect. One little known provision is a new 3.8% investment income surtax, also called the health care surtax or the Medicare tax, which will go into effect on January 1, 2013.
The health care surtax will be assessed on the lesser of a) net investment income or b) the excess of modified adjusted gross income (MAGI) over the “threshold amount.” This means:
1) If your modified adjusted gross income (MAGI) is less than or equal to the threshold amount that applies to you, you will not pay this tax.
2) If your modified adjusted gross income (MAGI) is greater than the threshold amount that applies to you, you will pay the 3.8% tax on the lesser of a) your net investment income or b) the amount of your MAGI over the threshold amount.
Net investment income: This is the sum of gross investment income over allocable investment expenses. For purposes of this surtax, investment income includes interest, dividends, capital gains, annuities, rents, royalties and passive activity income. It does not include active trade and/or business income; any of the income sources listed above (e.g., interest, dividends, capital gains, etc.) to the extent it is derived in active trade and/or business; distributions from IRAs and other qualified retirement plans; or any income taken into account for self-employment tax purposes. For the sale of an active interest in a partnership or S-corporation, gain is included as investment income only to the extent net gain that would be recognized if all of the partnership/S-corporation interests were at fair market value.
Modified adjusted gross income (MAGI): This is the sum of adjusted gross income (the number from the last line on page 1 of Form 1040) plus the net foreign income exclusion amount.
Threshold amount: For married taxpayers filing jointly, it’s $250,000; married filing separately, $125,000; all other individual taxpayers, $200,000. For trusts and estates, it is the beginning of the top income tax bracket ($11,650 in 2012).
Note: The surtax liability is determined on income before any tax deductions are considered. That means your deductions could put you in the lowest income tax bracket, yet you could still have investment income that is subject to the surtax. Also, the capital gain rate is scheduled to increase for high-income taxpayers to 20% in 2013, so the total tax on capital gains (with the surtax) could be 23.8% in 2013 and beyond.
Examples for Individual Taxpayers
* Olivia, single, has $125,000 of salary and $60,000 of net investment income. The 3.8% surtax will not apply because her MAGI is less than $200,000.
* Brian, single, has $250,000 of net investment income and no other income. The 3.8% surtax will apply to $50,000 of income (excess of $250,000 MAGI over $200,000 threshold amount).
* Bob and Sue, married filing jointly, have $350,000 in salaries and no other income. The 3.8% surtax will not apply because they have no investment income.
* Frank and Lily, married filing jointly, have $350,000 of salaries and $100,000 of net investment income. The 3.8% surtax will apply to $100,000 of net investment income because of the lesser than rule. (Their $100,000 net investment income is less than the amount of MAGI above their threshold amount: $400,000 – $250,000 threshold = $150,000).
Examples for Estates and Trusts
* The Steven Smith Trust has investment income of $25,000 and no distributions. $13,350 of income ($25,000 – $11,650 top bracket amount) will be subject to the 3.8% surtax.
* The Estate of Michael Smith earned $120,000 in interest and distributes 100% of income to the heirs. The Michael Smith Estate will not pay the 3.8% surtax; the income will apply towards each heir’s individual surtax determination.
Planning Considerations in 2012
There are several steps you can take this year to help you reduce or avoid the amount of surtax beginning in 2013. These include shifting investments, converting to a Roth IRA, deferring income, increasing contributions to tax-deferred plans, installment sales and charitable trusts.
2012 is also an exceptional year to do estate planning. The federal estate tax exemption is currently $5.12 million, which allows a married couple to remove as much as $10.24 million from their estate with no estate tax. Under current law, this exemption is scheduled to shrink to $1 million in 2013. Other Bush tax cuts, including income and capital gain taxes, are set to expire at the end of 2012. With the new 3.8% surtax becoming effective in January 2013 is on track to have the highest tax rates we have seen in years.
As always, be sure to seek expert advice on all tax-planning issues. Now, more than ever, clients need the advice and assistance of experienced professionals to help them implement the best plan for their family.
*The content of this article is adapted in part from information provided by the nationally recognized tax professionals at Keebler & Associates. For more information please visit their website at http://www.keeblerandassociates.com. The full text of the Health Care Act is available at http://housedocs.house.gov/energycommerce/ppacacon.pdf, with the relevant provisions beginning at Section 1411 at page 946.