Senior Vice President | CAPTRUST Financial Advisor
Chris Judy, CPA
Managing Partner | Thomas, Judy & Tucker, P.A.
With all the attention focused on the tax-rate changes included in the American Taxpayer Relief Act (ATRA), the legislation that narrowly averted the fiscal cliff, some may have forgotten about the new Medicare tax that actually resulted from a piece of legislation passed three years ago — the 2010 Health Care Act. Starting in 2013, high-income taxpayers are subject to a 3.8 percent Medicare “contribution tax on unearned income.” Judging by the number of client conversations and questions we have had on the topic, we thought it might be useful to dedicate some attention to it.
We asked Chris Judy, managing partner and certified public accountant at the Raleigh, N.C.-based accounting firm Thomas, Judy & Tucker, P.A., to provide his perspective on this new tax and share a few specific tax-planning strategies.
Who Pays This Tax?
The new 3.8 percent Medicare contribution tax will affect taxpayers whose adjusted gross income (AGI) exceeds certain thresholds—$250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately. These threshold amounts are not indexed for inflation. Thus, as time goes by, inflation will cause more taxpayers to become subject to the 3.8 percent tax.
Your AGI is the bottom line on page one of your Form 1040. It consists of your gross income minus your adjustments to income, such as an IRA deduction. If your AGI is above the threshold that applies to you, the 3.8 percent tax will apply to the lesser of:
• Your net investment income for the tax year, or
• The excess of your AGI for the tax year over your threshold amount.
This tax is in addition to the income tax that applies to that same income.
What is Net Investment Income?
The definition of net investment income subject to the 3.8 percent tax itself seems to be poorly understood. Interest, dividends, annuities, royalties, rents, and net gains from property and securities sales are all considered net investment income for purposes of this tax.
It is important to note that neither income from an active trade or business nor wage income is included in net investment income. However, passive business income is subject to the Medicare contribution tax. This is a very important distinction to recognize when considering strategies for dealing with the Medicare tax.
Are Home Sales Subject to the Tax?
If you sell your primary residence, you may be able to exclude up to $250,000 of gain, or gain of up to $500,000 for joint filers, when figuring your income tax. This excluded gain won’t be subject to the Medicare contribution tax. However, the amount of the gain that exceeds the limit on the exclusion will be subject to the tax. Gain from the sale of a vacation home or other second residence sale, which doesn’t qualify for the income tax exclusion, will be subject to the Medicare contribution tax.
Are Retirement Plan Distributions Taxed?
Distributions from qualified retirement plans, such as pension plans and individual retirement accounts (IRAs), aren’t subject to the Medicare contribution tax. However, keep in mind that those distributions may push your AGI over the threshold that would cause other types of investment income to be subject to the tax.
The income thresholds that trigger this new tax heighten the need to be proactive with your investment portfolio composition and management. Harvesting capital losses to offset gains may add value by allowing you to lower your AGI below the threshold applicable to you. Taking steps to avoid mutual fund capital distributions may also become more important for the same reason. While some year-end actions will always be available, having a clear picture of not only expected income levels but also its components is now far more important.
Income that is exempt from income tax, such as municipal bond interest, is likewise exempt from the 3.8 percent Medicare contribution tax, making municipal bonds potentially more valuable in a portfolio on a taxable-equivalent basis. Thus, switching some of your taxable investments into tax-exempt bonds can reduce your exposure to the 3.8 percent tax. Of course, this should be done with regard to your income needs, risk tolerance, and other investment considerations.
Life Insurance and Annuities
Deferring income until a later date through the use of life insurance or annuities is another strategy to consider. Investment vehicles like low-cost variable annuities provide the ability to shield investment earnings from the tax and could make sense for some individuals.
The Medicare tax also makes Roth IRAs more attractive for higher-income individuals because qualified Roth distributions are neither subject to the Medicare contribution tax nor included in AGI. If eligible, individuals may want to make Roth IRA contributions now so that those funds and any appreciation would not be taxable later.
Distributions from traditional IRAs will be included in AGI, except to the extent of after-tax contributions, although they are not subject to the Medicare contribution tax. If you are not required to take minimum distributions, you may want to limit your withdrawals in an effort to stay below the AGI threshold relevant to you. One way to ensure you stay below the threshold is to make retirement distributions directly payable to a charity of your choice. This option only applies to taxpayers who are over 70 1⁄2 and are making required minimum distributions.
In the past, some tax advisors have considered it beneficial to deal in passive activities; however, for the purposes of the Medicare tax, it is beneficial to be considered active in your rental or business dealings. Therefore, you may wish to review your activity level in rental and business ventures to consider if aggregation of activities to meet real estate professional and material participation status would be beneficial. By grouping business activities, you may be able to show material participation of over 500 hours, allowing those businesses to be considered active rather than passive. If you are considered active in a business or real estate activity, income from that activity would not ordinarily be subject to the Medicare tax.
Other Considerations for Business Owners
Business owners should be aware of several additional opportunities as they plan for the new Medicare tax:
• Entity selection is important when considering the impact of the Medicare tax. Currently, S corporation distributions are not subject to the Medicare tax, whereas distributions from C corporations are.
• One may wish to consider a Section 1031 Exchange to delay recognition of a gain on the sale of property.
• An installment sale may be used to spread gains over multiple tax years and avoid generating a large tax hit in a single year.
Our goal is to equip you with a few specific ideas that will help start conversations with your tax advisors about the new Medicare tax. These are conversations you should have as soon as possible so that you are in a position to properly consider strategies that will help minimize its impact going forward. Time spent now with both tax and investment advisors could yield lower taxes and better after-tax investment results for 2013 and beyond.