Are your Customers ready for the new 3.8% Medicare Tax on Investment Income? The U.S. Supreme Court upheld proposed tax increases that are part of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 ( 2010 Health Care Acts ), so that the 3.8% surtax on net investment income will begin to hit most high-income customers beginning in 2013. Starting in 2013, high-income households will start paying a 3.8% surtax on at least a portion of their income, such as capital gains and dividends. The 3.8% surtax will be applied to the lesser of a customer s net investment income or their Modified Adjusted Gross Income ( MAGI ) over the applicable threshold. The threshold for single filers is $200,000, while the threshold for married couples filing a joint return is $250,000. There are three critical elements associated with the 3.8% Medicare Surtax: 1. Net Investment Income a. Includes: interest, dividends, annuity income, rental income, capital gain income b. Does not include: salary, wages, bonuses, IRA and qualified plan distributions, social security income Taxable income from items that are not investment income can push taxpayers over the income threshold and cause investment income to be subject to the 3.8% surtax 2. Threshold Amount a. Single taxpayers - $200,000 b. Married taxpayers - $250,000 c. Estate/Trusts $11,950 in 2013 3. Modified Adjusted Gross Income is the amount that is compared to the threshold amount to determine the net investment income that is subject to the surtax. MAGI equals adjusted gross income PLUS any foreign income excluded from AGI. Who is Affected by the 3.8% Surtax? For certain customers, the crucial change will be a 3.8% surtax on investment income. For most customers, investment income will consist primarily of interest, dividends, capital gains, non-qualified annuity distributions and rental and royalty income. Luckily, traditional IRA distributions, including Roth conversions, as well as distributions from company plans are not considered investment income, but these distributions can trigger the 3.8% surtax. The first point to keep in mind is that this surtax affects only high income customers. For the purpose of this surtax, that s anyone with modified adjusted gross income (MAGI) over $200,000, or married couples with MAGI over $250,000 on a joint return ($125,000 for married taxpayers filing separately). Typically, a customer s MAGI will be the same as their AGI. However, any customers who exclude foreign income from AGI will have to include that amount when calculating their MAGI for the purpose of determining if they are over their applicable threshold. Keeping the MAGI thresholds in mind, the
3.8% surtax will be assessed on the lesser of (1) net investment income or (2) the amount of MAGI over the applicable threshold. Net investment income is gross investment income after investment expenses. Example #1: Alan and Beth Carter have MAGI of $300,000 in 2013 and file a joint return. Their net investment income is $20,000. Their MAGI threshold is $250,000. Therefore, the Carters are $50,000 over that amount. However, their $20,000 of investment income is smaller than their $50,000 of excess MAGI. As a result, the 3.8% surtax will be imposed on $20,000 - the lesser number of the two amounts and the Carters will owe a $760 surtax. Example #2: Dan and Eve Franklin. They have $300,000 of MAGI, but the Franklins income in 2013 includes $52,000 of net investment income. Now, the Franklins $52,000 of net investment income exceeds the $50,000 amount that they are over the $250,000 joint filer threshold. For the Franklins, $50,000 is the lesser number, so their surtax obligation is 3.8% of the $50,000 excess MAGI, or $1,900. Note that as long as their total $300,000 MAGI remained unchanged, it would make no difference if the Franklins net investment income was $52,000, $55,000, $155,000 or any higher amount. They will be $50,000 over the threshold and will owe a $1,900 surtax. Other Examples: John, single, has $100,000 of salary and $50,000 of net investment income. The 3.8% surtax would not apply (MAGI <$200,000). Mary, single has $225,000 of net investment income and no other income. The 3.8% surtax would apply to $25,000 of income (excess of $225,000 MAGI over $200,000 threshold amount ). Terry and Tina, married filing jointly, have $300,000 of salaries and no other income. The 3.8% surtax would not apply (no net investment income). Peter and Paula, married filing jointly, have $400,000 of salaries and $50,000 of net investment income. The 3.8% surtax would apply to $50,000 of net investment income (lesser of rule. Their MAGI is $150,000 over the threshold, but their net investment income is only $50,000). Scott and Sarah, married filing jointly, have $200,000 of salaries and $150,000 of net investment income. The 3.8% surtax would apply to $100,000 of income (lesser of rule excess of $350,000 MAGI over $250,000 threshold amount ).
How IRA Distributions Impact the 3.8% Surtax IRA and other retirement account distributions are not considered investment income for purposes of the 3.8% surtax. So where, then, do IRAs come into this calculation? These distributions can cause other net investment income to be hit with the surtax when that income otherwise would have avoided it. Roth Conversion Example: Greg and Heidi Ingram file a joint return and have MAGI in 2013 of $240,000. They have $60,000 of net investment income, but since they are $10,000 below the joint filer threshold of $250,000, they re not concerned about the impact of the 3.8% surtax. It does not apply to them. Now assume the Ingrams convert a $100,000 traditional IRA to a Roth IRA in 2013. Even though their net investment income is unchanged, the Ingrams now have a $340,000 MAGI, so they are over the joint threshold by $90,000. Now the Ingrams will have to pay the surtax on their $60,000 of investment income in 2013 (since the $60,000 of investment income is less than the $90,000 amount over the threshold), which amounts to an additional tax liability of $2,280. Here, converting a traditional IRA to a Roth IRA in 2013 triggered a surtax of thousands of dollars where the surtax otherwise would have been completely avoided. Remember, the 3.8% is in addition to the regular income tax the conversion normally generates. RMD Example 1: Randy, a single taxpayer, age 69, has net investment income of $200,000 and is not subject to the surtax. In the following year, Randy has an RMD from his IRA of $125,000. In this case, his RMD increases his MAGI to $325,000 which exceeds the $200,000 threshold and now his $125,000 of net investment income is subject to the 3.8% surtax. Customers like Randy with sizable RMDs, could run into this problem year after year since he will be forced to withdraw ever greater percentages of his IRA account as an RMD. Reducing MAGI through Increased Retirement Account Contributions How can you help customers minimize the surtax bite? One way would be to suggest that customers maximize, or at least increase, deductible contributions/salary deferrals to 401(k)s, SEPs, IRAs and other retirement accounts. Salary deferrals to 401(k)s and similar plans are excluded from gross income and contributions to SEP IRAs for self-employed customers, as well as deductible traditional IRA contributions, are above-the-line deductions that reduce AGI (and therefore MAGI as well). Reducing MAGI through Roth Conversions Whether customers are still working or have already retired, those with high incomes who execute Roth IRA conversions or take RMDs from traditional IRAs after 2012 might owe the 3.8% surtax as well as ordinary income tax. Given that the top federal income tax rate is scheduled to rise from 35% to 39.6% in 2013, the total tax on a future Roth IRA conversion or traditional IRA distribution could be as high as 43.4% (39.6% + 3.8% = 43.4%). See the chart at the end of the article.
Therefore, you might suggest that high-income customers convert their traditional IRAs to Roth IRAs by year-end. They ll owe tax at rates no higher than 35%, which could turn out to be much less than they will owe in the future. (This year also might be a good time to sell long-term capital gain property to help pay for the tax on the conversion, while the top long-term capital gains rate is still 15%.) Roth IRA owners never have to take RMDs. Therefore, converting a traditional IRA to a Roth IRA can reduce a customer s future MAGI and reduce exposure to both higher ordinary tax rates and the 3.8% surtax. Furthermore, since qualified Roth IRA distributions are tax-free, qualified Roth IRA distributions taken voluntarily in the future won t increase a customer s MAGI causing other investment income to become subject to the surtax. Customers may not be eager to pay so much in tax today, even at the current 35% low rate, versus a potential 39.6% tax rate in the future. However, the inclusion of the 3.8% surtax makes the possible gap much wider 35% now instead of 43.4% in the future so customers may be more interested in a full, or even a partial, Roth IRA conversion in 2012. A full or partial Roth IRA conversion may not be suitable for every customer. However, you probably should be having the conversation with customers now, especially those with high incomes who ll face not only steep ordinary tax rates but also the 3.8% surtax in future years. Even if customers do not heed your advice, it is important to have this conversation and document it for future reference. Itemized Deductions Won t Reduce MAGI What if your customer has large itemized deductions, so large that they substantially reduce their taxable income? Will that reduce their MAGI for the 3.8% surtax? That won t work. Itemized deductions are known as below-the-line deductions. They do not reduce AGI and, in turn, do not reduce MAGI. Using Gifts to Minimize Exposure to the Surtax The lifetime gift tax exemption will shrink increase $5.25 million in 2013 to $5.34 million in 2014. Therefore, wealthy customers may want to make large gifts, shrinking their taxable estates without triggering gift tax. Another goal may be to reduce the future burden of the 3.8% surtax. Gifts can be used to pass money down to a child, or even up to a parent, to help pay the tax on Roth conversions. Gifts can also be used to fund life insurance policies. Planning with Non-Qualified Deferred Annuities to Avoid the Surtax Beyond IRAs, 401(k)s, etc., putting money into non-qualified deferred annuities can help reduce MAGI in the future but still increase one s retirement savings. Taxable income from non-qualified deferred annuities is considered investment income. However, these investments may also help minimize surtax exposure as well, keeping interest and dividends free from the surtax while accumulating in the annuity. However, each individual s situation will differ depending on whether they need current income Looming Changes to the Medical Expense Exception to the 10% Penalty In addition to the 3.8% surtax, some other provisions of the federal health insurance legislation will affect retirement plans. For instance, beginning in 2013 it will become more difficult to use the medical expense exception to avoid early withdrawal penalties from IRAs and other tax-favored plans.
The 10% penalty for early distributions generally applies to withdrawals before age 59½, but some withdrawals from company plans avoid the penalty after age 55 if there is separation of service. Under current law, distributions from IRAs and company plans used to pay unreimbursed medical expenses over 7.5% of AGI are granted an exception and aren t subject to the 10% penalty. However, under the 2010 Health Care Acts, the threshold for this penalty exception rises from the 7.5% of AGI in place now, to 10% of AGI in 2013. A Premium on Tax Planning Now that the 2010 Health Care Acts are here to stay (barring a legislative repeal) higher taxes for highincome taxpayers are almost a certainty beginning in 2013. If customers can reduce their income and/or net investment income, beginning next year they ll reduce their exposure to the 3.8% surtax, and to the higher income tax rates now scheduled to take effect. It s no secret that as tax rates rise, the need for competent tax planning becomes even more important. What does this mean for your Business? Your customers should speak to their tax and legal advisor about the following: All customers should talk to their tax advisors to see how increased tax rates would affect them. High-income customers should discuss the recently-upheld health care acts, including the mechanics and impact of the 3.8% surtax. Customers may want to investigate Roth IRA conversions or taking long-term capital gains before yearend 2012, while tax rates are still relatively low. Customers with potential estate tax issues should discuss the potential benefits of using the $5.25 million (2013) gift tax exemptions ($10.50 million for married couples) before year-end. For customers who are still working, emphasize the increased importance of deductible retirement plan contributions, starting next year.
The 3.8% Investment Tax is Here to Stay A Comparison of the Top Federal Tax Rates for Different Types of Income Income Type 2012 2013 % Increase Taxable IRA distributions and Roth conversions (Ordinary Income) 35% 39.6% 13% Short-term Capital Gains 35% 43.4%* 24% Long-term Capital Gains 15% 23.8%* 59% Interest Income 35% 43.4%* 24% Qualified Dividend Income Qualified Roth IRA Distributions 15% 43.4%* 189% 0% 0% 0% *In 2013 the top federal tax rate includes income taxes and the 3.8% surtax on investment income. This information is provided for general broker educational purposes and is not to be relied upon in any decision with respect to planning opportunities. Allstate cannot predict actual tax consequences for any given situations because relevant tax law, which may include statues, regulations, or rulings, is subject to change. This information is not intended to provide legal, tax or investment advice. For individual advice, a legal or tax advisor should be consulted. Please note that Allstate Life Insurance Company or its agents and representatives cannot give legal or tax advice. The brief discussion of taxes in this article may not be complete. The laws and regulations are complex and subject to change. For complete details an attorney or tax advisor should be consulted.