WEALTH MANAGEMENT UPDATE

Planning for 2013’s 3.8% Medicare Surtax


The Patient Protection and Affordable Care Act (“Act”) was signed into law by President Obama on March 23, 2010. While certain elements of the legislation have already begun to take effect, one in particular won’t begin until January 1, 2013. Still, individuals and fiduciaries alike should be mindful of the Act’s Unearned Income Medicare Contribution used to help finance the healthcare reform. The contribution takes the form of a surtax of 3.8 percent on certain types of unearned income of individuals, trusts and estates with income above specific thresholds. Furthermore, absent Congressional action, the top income tax rates are set to increase in 2013. As a result, the future top income tax rate of 39.6 percent would increase to 43.4 percent due to the surtax. In addition to ordinary income rates, the top capital gain rate is set to increase to 20 percent in 2013.

It should be noted that while the Act’s constitutionality was adjudicated in several state courts in 2011, the US Supreme Court upheld the Act in a 5-4 decision on June 28, 2012. Fortunately, there are ways to plan for the 3.8 percent surtax. The contents of this Wealth Management Update serve to explain the rules regarding when the surtax applies, provide examples of when the surtax applies, offer some planning strategies to eliminate or mitigate the additional tax liability, and explain the surtax’s application with respect to home sales.


Who Is Affected?

The surtax will apply to individuals, trusts and estates if certain thresholds are met.

  • For individuals, the 3.8 percent surtax is imposed on the lesser of:
    • Net investment income for the tax year; or
    • The amount by which the modified adjusted gross income (MAGI)[i] exceeds the “threshold amount” in that year.
  • The threshold amounts are as follows:
    • $200,000 for single filers
    • $250,000 for married filing jointly
    • $125,000 for married filing separately
  • For trusts and estates, the 3.8 percent surtax is imposed on the lesser of:
    • The undistributed net investment income for the tax year; or
    • The excess (if any) of the taxpayer’s adjusted gross income over the dollar amount at which the highest tax bracket begins ($11,650 in 2012).

The Act does not apply to nonresident aliens.


Net Investment Income

In order to determine if the surtax applies, it is important to understand what qualifies as net investment income. Net investment income includes the following items, reduced by any deductions allocable to such income:

  • Interest, dividends, royalties, annuities, rents
  • Income derived from passive activities
  • Trading financial instruments and commodities
  • Net capital gains derived from the disposition of property (other than property held in an active trade or business)

Net investment income does not include the following:

  • Active trade or business income
  • Gain on sale of an active interest in a partnership or S corporation
  • Distributions from IRAs or qualified retirement plans
  • Income from tax exempt municipal bonds
  • Tax deferred non-qualified annuities
  • Income taken into account for self-employment tax purposes
  • Capital gain excluded under I.R.C. §121


Examples of the Surtax

The following examples illustrate the application of the rules pertaining to the surtax. For each example, assume the facts apply in 2013.

  • Single Individual. Single taxpayer has $215,000 of net investment income and no other sources of income. The 3.8 percent surtax applies to $15,000 of income since it is the lesser of net investment income of $215,000 or the excess over the MAGI threshold of $200,000.
  • Married Filing Jointly without Net Investment Income. Husband and wife, filing jointly, earn $275,000 in salaries and do not have any net investment income. The 3.8 percent surtax does not apply since there is no net investment income.
  • Married Filing Jointly with Net Investment Income. Husband and wife, filing jointly, earn $200,000 in salaries and $150,000 of net investment income for a total MAGI of $350,000. The 3.8 percent surtax applies to $100,000 of income since it is the lesser of $150,000 of net investment income or the excess over the MAGI threshold of $250,000.
  • Roth IRA Distribution. Husband and wife, filing jointly, have $130,000 of 401(k) income and $110,000 of net investment income. Wife took a $50,000 distribution from her Roth IRA. The couple has MAGI of $240,000. The 3.8 percent surtax does not apply because the couple’s MAGI is below the $250,000 threshold. Note, qualifying Roth IRA distributions are not taken into account for income purposes, nor is the distribution deemed net investment income.
  • Traditional IRA Distribution. Husband and wife, filing jointly, have $130,000 of 401(k) income and $110,000 of net investment income. Wife took a $50,000 distribution from her Traditional IRA. The couple has MAGI of $290,000. The 3.8 percent surtax applies to $40,000 of net investment income, the lesser of the net investment income of $110,000 or the amount over the $250,000 threshold. Note, Traditional IRA distributions are not classified as net investment income; however, they are considered for MAGI purposes.
  • Trust with No Distributions. Trust has investment income of $60,000 and has not made any distributions during the tax year. The 3.8 percent surtax applies to $48,800 of income, the lesser of the net investment income of $60,000 or the amount over the $11,650 threshold.
  • Trust with Distributions. Trust has investment income of $60,000 and during the tax year has distributed 100 percent of the income. The 3.8 percent surtax will not apply to the trust since it did not retain any investment income. However, depending upon the beneficiary’s situation, the surtax may apply as to him/her.


Mitigation Strategies and Planning Opportunities

When planning for the 2013 surtax, the strategies detailed below may be utilized to manage the income threshold limits, as well as the amount of net investment income incurred by the taxpayer. When considering such strategies, it is important to determine whether or not they fit into your overall, long-term plan. While tax planning is always important, it is worth keeping in mind that it is only one element of a comprehensive plan.

  • Roth IRAs:
    • Roth Distributions. Distributions from Roth IRAs are not taken into account when analyzing the income thresholds for the taxpayer, nor are they considered net investment income.
    • Roth Conversions. While converting a Traditional IRA to a Roth IRA is a taxable event, Roth IRAs can offer more flexibility than Traditional IRAs due to their tax-free nature and the absence of required minimum distributions. If you are contemplating converting a Traditional IRA to a Roth IRA, consider paying for the tax liability from a source other than the IRA. If the tax is paid from a taxable portfolio producing net investment income, that portion of the portfolio used will be shielded from the surtax.
  • Traditional IRAs:
    • Contributions. Making deductible contributions ($5,000 max, $6,000 max for those over age 50) to an IRA will lower one’s MAGI. However, non-deductible contributions will not reduce your MAGI.
    • Distributions. Traditional IRA owners are required to take minimum distributions upon reaching age 70 ½. While such distributions are not considered net investment income, they will count toward the surtax’s income thresholds.
  • Maximize Qualified Retirement Plan Contributions. Current contributions to qualified retirement plans reduce income, which would keep income below the MAGI thresholds. In addition, distributions from such plans are not considered net investment income. However, distributions from such plans will be taken into account for the MAGI threshold limitations. Such plans may include employer-sponsored defined benefit plans, profit sharing plans, money purchase plans, ESOPs, 401(k) plans, 403(b) plans, or 457(b) plans.
  • Municipal Bonds. Income from municipal bonds is not considered net investment income, nor is it considered for purposes of the surtax’s income thresholds. As such, it may make sense to consider rebalancing a portion of an investment portfolio to increase its municipal bond exposure. While rebalancing may trigger capital gains within the portfolio, it may be advantageous to pay those gains now since the capital gains rate is set to increase in 2013, absent Congressional action.
  • Wealth Transfer Planning:
    • Outright Gifts to Individuals in Lower Income Brackets. Gifting ordinary income or net income producing property to such individuals will remove the asset from the donor’s possession, thereby reducing the income to him/her from such asset. Note, such a gift may trigger gift tax to the donor.
    • Family Limited Partnerships (FLPs). FLPs can serve as vehicles to shelter a portion of an individual’s net investment income. Parents can employ the FLP structure to gift partnership interests to younger generations so as to reduce their own net investment income that may be subject to the surtax, as well as distribute such interests to a group of individuals who may be below the MAGI thresholds. The planning strategy can also help the parents reduce the size of their gross estate for estate tax purposes.
  • Charitable Planning:
    • Outright Gifts to Charity. Gifting income-producing property outright to a charity can remove such asset from the donor’s possession, thereby reducing the income associated with the asset. Furthermore, the gift may result in an immediate charitable income tax deduction for the donor which may reduce his/her income.
    • Charitable Remainder Trusts (CRTs). A CRT is a split interest trust consisting of both an income and remainder interest. During the trust term, the non-charitable beneficiary receives an income interest, with the remainder passing to the charity at the end of the trust term. Structuring a level income stream during the trust term may keep the beneficiary’s income below the surtax’s threshold limits. In addition, transferring property to a CRT affords the donor an immediate charitable income tax deduction for the present value of the remainder interest passing to charity. The deduction can be used to offset income. Furthermore, CRTs are tax-exempt entities. As a result, the trust has the ability to sell the contributed assets free of tax and then reinvest the proceeds as it sees fit.
    • Charitable Lead Trusts (CLTs). A CLT is a split interest trust consisting of both an income and remainder interest. During the trust term, the charity receives the income interest, with the remainder passing to the non-charitable beneficiary. Upon creating a grantor CLT, the donor will receive a charitable income tax deduction equal to the present value of the income interest transferred to the charity. The deduction can be used to offset net investment income.
  • Business Succession Planning:
    • Installment Sales. The installment sale is a type of sale whereby an asset is sold in exchange for a promissory note paid over a period of time. Installment sales may be used to limit the amount of net investment income in any one year, as well as manage the taxpayer’s MAGI so as to avoid exceeding the income thresholds. The application of the surtax with respect to installment sales is dependent upon the type of asset sold. If an active business interest were sold, the capital gain would not be considered net investment income, yet would be taken into account for MAGI purposes. Alternatively, if a piece of raw land were sold for a gain, the gain would be considered net investment income and would affect the taxpayer’s MAGI. However, if an installment sale were used, the gain could be spread over a period of time. If there is an opportunity to sell an asset prior to 2013, the potential advantage of a lower capital gains tax rate and no surtax should be considered in evaluating the transaction.
    • Gains on Sale of Business Property. Net investment income does not include gains on the sale of business property from an active trade or business. While the sale proceeds are not considered net investment income, they will be taken into account for MAGI threshold purposes. Furthermore, absent Congressional action, the top capital gain rate is set to increase to 20 percent in 2013. If a transaction occurs prior to 2013, the taxpayer can take advantage of the current lower capital gain rate.
  • Lower Annual Income Through Deferral. Defer income over time to reduce your income each year below the MAGI threshold.
  • Qualified Stock Option Planning. Consider an early exercise of qualified stock options, also known as incentive or statutory stock options. The exercise of qualified stock options does not trigger taxable income upon exercise; however, it starts the long-term capital gain holding period. If exercised before the end of 2011, the stock could be sold at current capital gains rates before the surtax becomes effective in 2013.
  • Minimize Sources of Net Investment Income Such As:
    • Passive activity income
    • Limited partnership income
    • Gains on sales of passive property
    • Rental real estate income
    • Income with no material participation
    • Undistributed taxable income from trusts
  • Discretionary Distributions from Trusts. If a Trustee has the ability to make non-pro rata allocations among beneficiaries, it may make sense in some cases to distribute more net investment income to the lower income trust beneficiary in order to avoid the surtax.


Sale of a Personal Residence

Some confusion exists around the applicability of the surtax with respect to home sales. It should be noted that home sales have the ability to trigger the surtax if:

  • The taxpayer’s MAGI exceeds the $200,000/$250,000/$125,000 threshold, and
  • The taxpayer engages in the sale of a principal residence resulting in a capital gain greater than the IRC Section 121 exclusion ($250,000 for single taxpayers and $500,000 for married couples) and/or engages in the sale of a non-principal residence that results in a capital gain.

The following examples, illustrate the rules:

  • A married couple earns a combined salary of $100,000. They sell their principal residence in 2013 for $700,000 and net a gain of $640,000. Their MAGI in the year of the sale is $240,000 (salary plus $140,000 gain above $500,000 exclusion). Because their MAGI is less than the $250,000 threshold, they do not pay the 3.8 percent Medicare tax.
  • A married couple earns a combined salary of $2 million. They sell their principal residence in 2013 for $1.2 million and net a gain of $700,000. Their MAGI in the year of the sale is $2.2 million (salary plus $200,000 gain above $500,000 exclusion). Because their MAGI is more than the $250,000 threshold, they will have to pay the 3.8 percent Medicare tax. Their net investment income is $200,000 ($700,000 minus $500,000) and the excess of their MAGI over the threshold is $1.95 million ($2.2 million minus $250,000). Their tax is therefore 3.8 percent of $200,000 or $7,600. Note, if the sale were completed in 2012, the surtax would not apply to the transaction because the surtax would not be effective yet.

Conclusion

As mentioned previously, income tax planning is one element of wealth planning. It is important to analyze the aforementioned mitigation strategies in conjunction with the other elements of your wealth plan to determine if they are appropriate and satisfy your overall goals and objectives.

To learn more about these strategies, contact your Wells Fargo relationship manager who will work with your tax advisors and a Wells Fargo Wealth Planning Strategist to determine the right approach based on your specific circumstances.


Disclosures

Wells Fargo Wealth Management and the Wealth Planning Center provide products and services through Wells Fargo Bank, N.A., and its various subsidiaries and affiliates. Investment products and brokerage services are available through Wells Fargo Advisors, LLC, (member SIPC), a non-bank affiliate of Wells Fargo & Company. Insurance products are available through insurance subsidiaries of Wells Fargo & Company and underwritten by non-affiliated Insurance Companies. Not available in all states.

This information is provided for education and illustration purposes only. The information and opinions in this report were prepared by the Wealth Planning Center within Wells Fargo Private Bank. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Private Bank’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Private Bank does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

Wells Fargo and Company and its affiliates do not provide Legal advice. Please consult your tax or legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.

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[i] Modified adjusted gross income (MAG) is determined by taking an individual’s adjusted gross income and adding back certain items such as foreign income, foreign-housing deductions, student-loan deductions, IRA-contribution deductions and deductions for higher-education costs.

 

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Planning for 2013’s 3.8% Medicare Surtax (PDF)
June 28, 2012

The Patient Protection and Affordable Care Act was signed into law by President Obama on March 23, 2010. While certain elements of the legislation have already begun to take effect, the surtax of 3.8% on certain types of unearned income of individuals, trusts, and estates won't begin until January 1, 2013. In this Wealth Management Update, Michael Morrone, Associate Director of Client Management, explains the rules regarding when the surtax applies, and offers some planning strategies to mitigate the surtax. 

 

Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.

Wells Fargo Wealth Management provides financial products and services through Wells Fargo Bank, N.A. and their various affiliates and subsidiaries. The information and opinions in these reports were prepared by the Investment Management arm of Wells Fargo Private Bank, a part of Wells Fargo Wealth Management and a division of Wells Fargo Bank, N.A.

Investments discussed in these reports may not be insured by the Federal Deposit Insurance Corporation and may be unsuitable for some investors depending on their specific investment objectives and financial position. These reports are not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned.

Brokerage services offered by Wells Fargo Advisors, LLC. Wells Fargo Advisors, LLC, Member SIPC is a registered broker-dealer and separate non-bank affiliate of Wells Fargo & Company.

 

Investment Products: Not FDIC Insured, No Bank Guarantee, May Lose Value.