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3.8% Medicare Surtax & 0.9% Medicare Surtax & IRS Enforcement…Oh My!

Unless you’ve been living under a rock for the last year, I am sure you have heard that this year there are big changes for some individuals when they file their Federal Income Tax. Some of these changes come from provisions from the PPACA (Patient Protection and Affordable Care Act a.k.a. Obamacare) that took effect this year, placing a 3.8% tax on various forms of investment income for individuals and a 0.9% surtax on wages and self-employment income over a threshold amount.

These are a huge deal because they are both surtaxes, meaning they are in addition to any other tax assessed on income. Both surtaxes apply only if your modified adjusted gross income is over $250,000 married filing joint, or $200,000 single. So, if your top income tax bracket is 39.6%, this 3.8% surtax on net investment income puts your overall federal rate at 43.4%. Secondly, if your wages and/or self-employment income exceed the threshold amounts, you are going to pay the 0.9% surtax on the wages and/or self-employment income over that threshold amount. Generally employees pay Medicare taxes at a rate of 1.45% on all wages. With this new provision certain employees will end up paying 2.35% on wages over the threshold. The employers will be responsible for collecting and remitting these on wages paid (if wages paid from that employer exceed the threshold) and self-employed taxpayers will pay it in with their 2013 tax return.

In an effort to make this extremely clear, what I am saying is that a taxpayer in the highest tax bracket living in Michigan and residing in a city which has a city income tax, will be paying approximately $0.50 in taxes on every $1.00 they earn (over the threshold amounts). Every taxpayer is different and that is why it is essential to do tax planning with your CPA. Some of these impacts can be lessened or even eliminated with proper planning. However I will add a prerequisite to that…sometimes when you are really wealthy and all the planning is said and done, you may just be stuck paying the tax. We are all for tax avoidance, but not tax evasion…correct?

A few general planning items to consider:

  • Timing income:In some cases, it may be as simple as timing income so that you don’t have an influx of investment income in the same year as you have high overall income. You can delay or accelerate income to a year that you expect to be below the threshold amounts or you can try to offset gains with losses, etc.
  • Non-net investment income products:Some gains are excluded from income for regular tax purposes, and would therefore not be subject to the 3.8% surtax. One example would be the internal buildup of value inside a life insurance policy. A strategy for this would be to use a cash value life insurance policy as a way to accumulate dollars without increasing your net investment income.
  • Combine with other planning strategies:If you have charitable giving plans, it may be tax-wise to use charitable techniques that avoid the surtax. A Charitable Remainder Trust (CRT) is a vehicle that can be particularly useful in planning to avoid the impact of the net investment income because the CRT is exempt from the new Medicare Surtax. A planning tip for property having significant appreciation is to transfer it to a CRT, where it can then be sold without the imposition of the 3.8% tax (or the imposition of any regular income tax). By placing an investment in a CRT, you can 1) obtain a charitable tax deduction, 2) avoid taxes on gain in the investment and 3) leave the remainder for the benefit of the charity

These particulars of these new surtaxes, especially the 3.8% net investment income tax, are still being developed by the IRS, so the available planning strategies are kind of a moving target. But if you, or someone you know, is concerned about how the impact of these new taxes, please contact me at 517-788-8660 or to discuss the issue. At the very least, we can get you prepared for the impact of the taxes before they are actually due. And, if your situation is right, we can do some planning to avoid the taxes going forward.