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Planning for the New Medicare Surtaxes

These moves may save your clients some money next year.

Sandra L. Atkins and Helen Modly, 09/13/2012

At this point, it looks like the 0.9% Medicare surtax on earned income and the 3.8% Medicare tax on unearned income will both go into effect on Jan. 1, 2013. Use last year's tax return to determine if your clients are likely to pay these new taxes. If they are, you still have time to recommend some moves this year that will save them money next year.

The Patient Protection Affordable Care Act--commonly known as the health-care bill--was passed in March 2010. It included the imposition of Medicare taxes targeted at high net worth individuals to begin in 2013.

Not Everyone Will Pay
Most Americans will escape paying the new Medicare taxes on both earned and unearned income. In order for the tax to apply, there is a threshold amount, and those who fall under the threshold will escape these taxes completely.

The 0.9% tax is based on earned income in excess of $200,000 for singles and $250,000 for married couples. The employer will collect the tax on all salaries and bonuses paid in excess of $200,000, so married filers may either get a credit on their tax return or owe additional tax, depending on the earnings of the other spouse.

The 3.8% tax is based on unearned income for taxpayers who have modified adjusted gross income (MAGI) in excess of $200,000 for single filers and $250,000 for married filers. Net investment income basically includes interest income (except for municipal bond interest), dividends, capital gains, the taxable portion of annuity distributions, net rents and royalties, and passive income.

Taxable trusts have the worst deal with respect to the 3.8% tax. The threshold for trusts is only $11,650 for 2012. All investment income in a taxable trust should be passed through to the beneficiaries whenever possible so that higher individual threshold amounts apply.

How to Estimate Your Clients' Tax Exposure
It's not your job to calculate taxes for your clients, but if you spend a few minutes checking their potential Medicare tax for next year, you can provide a valuable service. This exercise is a guess at best, but it gets your clients thinking about the issues and can be very helpful for those who have some ability to control the timing of their income.

Let's use Jay and Eleanor as an example. Jay takes a salary of $350,000 from his S-corporation, which typically has $30,000 of net income reported on Jay's Schedule E. Eleanor has a part-time job earning $20,000, runs a small business with a profit of $6,000, and has taxable annuity income of $18,000 per year from an employer-sponsored retirement plan. They have interest and dividend income of $3,000 and $7,000, respectively, and capital gains from the sale of securities of $14,000. How much Medicare tax will they owe?

The following chart calculates an estimate of their tax. Note that Eleanor's annuity is not considered unearned income because it is a retirement plan distribution. Jay's S-corporation profit reported on Schedule E is not included in either tax--it is a distribution from an active business, so it's not passive investment income, but it is not subject to self-employment taxes so it's not considered for the earned income Medicare tax, either. To help you identify the income from LLCs, partnerships, and Schedule Cs that is considered earned income, take a look at the clients' self-employment tax form, Schedule SE.

Jay and Eleanor can expect to pay $2,046 for the new Medicare taxes--not enough to break the bank for this couple. In this situation, Jay would have had $1,350 withheld from his salary ($350,000 x 0.9%) for the tax on the earned portion. Since this exceeds his actual Medicare tax liability of $1,134, he will get a credit for the excess tax when he files his return.

What's the Benefit to Your Client?
The point of this exercise is not to identify the exact tax the client will owe--that's impossible based on information readily available to you. In fact, at this point, we just have the 2011 tax return to look at, and the tax will apply to income in 2013. The value proposition here is to demonstrate to your client that you are keeping an eye on their entire situation. You can immediately put to rest the minds of clients whose MAGI and earned income are under the thresholds, since they will avoid the taxes completely.

The clients you need to talk to now are those who have opportunities to control the timing of their income. Keep in mind that you are trying to reduce the tax itself plus minimize the income in 2013 to get under the thresholds. For instance, choosing to recognize a capital gain in 2012 avoids the 3.8% tax in 2013 and also reduces the MAGI for 2013, perhaps keeping it under the threshold for next year.

It's very important to look at taxes right away to help clients plan for the rest of 2012. We have a one-time opportunity to accelerate income into this year, both in anticipation of the new Medicare tax as well as the potential for higher income tax rates due to the expiration of the current taxes. Following are some ways that income can be accelerated to 2012 to avoid the tax next year:

--Take a bonus this year to save the 0.9% for a high-income earner

--Sell investment assets to save the 3.8% tax next year

--Accelerate income in a small business or partnership to save either tax, depending on whether it is an active or passive business

--If you are planning a Roth conversion, do it in 2012

Strategies to Reduce the Medicare Taxes Going Forward
There are also several opportunities to minimize the Medicare tax on unearned income by controlling the asset type and location. Some are fairly easy to accomplish, while others are less so. Before you even consider making any adjustments, you first need to know whether or not your client is subject to the Medicare tax on unearned income. If so, then you should keep in mind ways to minimize the taxes when you are evaluating their portfolio.

The following are some strategies to reduce net investment income and MAGI:

--Purchase tax-exempt bonds

--Pay attention to asset location--put equities with high dividends and bonds with high interest into retirement accounts, and equities with high capital appreciation in taxable accounts

--Bunch discretionary income into the same year whenever possible so that some years the MAGI stays under the threshold

--Consider tax-deferred annuities, which will save the tax now but be taxed in the future when the payments are withdrawn

--Add real estate investments where the income is sheltered by depreciation

--Convert IRA assets to a Roth--even though the future distributions from both traditional and Roth IRAs are not treated as net investment income, the Roth will not increase the threshold income

--Reduce MAGI by "above-the-line" deductions, such as deductible contributions to IRAs and qualified plans, and health savings accounts

The Time Is Now
Taking a quick look at your clients' tax returns will give you a sense of whether or not they may be subject to the Medicare surtaxes. Even if you choose not to calculate an estimate of the tax, you definitely should talk to them about ways you can help them minimize the tax through portfolio design, and then send them to their CPA for some year-end tax planning.

Sandi Atkins, CPA/PFS, is president of Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. In 2008, she was named by Wealth Manager Magazine as one of the 50 Distinguished Women in Wealth Management.

Helen Modly, CFP, ChFC, is executive vice president and director of investment services for Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 20 years of experience providing wealth-management services. She is a member of NAPFA and FPA. She can be reached at info@focus-wealth.com.

The authors are not employees of Morningstar, Inc. The views expressed in this article are the authors'. They do not necessarily reflect the views of Morningstar.

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