Healthcare Surtax

The healthcare legislation signed into law this year was among the most voluminous in recent history. As with all things government-related, it is challenging to decipher and understand how it will affect you and me. I recently attended the national conference for the National Association of Personal Financial Advisors, where after two hours, the presenter was able to highlight only the basics of the legislation.

As such, I will not try to cover every aspect of the bill in this short article. The majority of Americans are most concerned with how this will impact their tax pocketbooks via the Medicare surtax. This article will discuss the tax and planning ideas for ways to minimize the impact to you.

The Tax

Effective January 1, 2013, if your Modified Adjusted Gross Income (MAGI) exceeds the threshold ($250,000 for married filing joint filers and $200,000 for single filers), then you could be subject to a 3.8% surtax. This surtax applies to the lesser of net investment income or the amount by which your MAGI exceeds the threshold.

I work better with examples, so here are a few:

• Joe is single and has $100,000 of salary and $75,000 of net investment income. The surtax would not apply as his total MAGI is less than $200,000.
• Tom and Nancy are married and have total salary income of $350,000 but no other income. The surtax would not apply because they have no investment income.
• Jack and Diane are married and have $400,000 of salary income and $70,000 of net investment income for a total MAGI of $470,000. The surtax would apply to $70,000 of net investment income (though their income exceeds the threshold by $220,000, the surtax will only apply to the $70,000 of investment income).
• Sylvia and Harry are married and have $200,000 of salary income and $150,000 of investment income for a combined MAGI of $350,000. The surtax would apply to $100,000 of their investment income (as this is the amount by which their MAGI exceeds the threshold).

For most taxpayers, investment income will include interest, dividends, capital gains, annuity payments, rental income and passive activity income. Investment income does NOT include business or self-employment income or distributions from IRAs or other qualified plans and is therefore excluded from the surtax. However, income from these excluded sources is included in the calculation to determine if your MAGI exceeds your limit and can trigger the surtax. For example:

Ben is a 69-year-old single taxpayer with only investment income totaling $200,000. Therefore, he is not subject to the surtax. In the following year, he has the same amount of investment income but is also forced to take his Required Minimum Distribution (RMD) of $75,000, bringing his combined MAGI to $275,000. In this case, $75,000 of his investment income is subject to the surtax as he exceeds the $200,000 limit.

Note that trusts and estates with taxable income are also subject to the surtax to the extent that their MAGI exceeds the income at which the highest tax bracket applies ($11,200 in 2010). This should be reviewed further with your CPA and/or estate attorney.

Planning Opportunities

Now that we have discussed a little bit about the tax, let’s review a few techniques to minimize its impact to you:

Qualified retirement plans
If you are still working, maximizing your contribution to employer plans is a great way to reduce your taxable income.

Roth IRAs
The conversion of traditional IRA assets to a Roth IRA is potentially taxable and in 2013 will be included in the calculation of MAGI for surtax purposes. However, qualified distributions from a Roth IRA are not included in taxable income or the calculation of MAGI for surtax purposes. By converting assets to a Roth IRA, you also reduce your traditional IRA asset balance and thereby reduce future RMDs and future surtax exposure. 2010 is a special year for the Roth conversion. See our previous Viewpoint on Roth IRAs for more information.

Tax exempt and other alternative investments

Municipal bonds retain their tax-exempt status. However, these investments typically come with a lower yield. Other investment alternatives such as real estate or oil and gas investments also offer deferral of income. However, these can create other tax complexities that should be explored before purchased.

Accelerating income before 2013
The long-term capital gains tax rate will return to 20% in 2011, absent any unlikely intervention by Congress. Therefore, if you are currently sitting on large capital gains, it might make sense to take some of those gains now and utilize the current 15% capital gains rate. In addition, by taking gains now, you could potentially reduce your investment income for the 2013 surtax. Additionally, if other income is to be incurred (deferred compensation, bonuses, etc), and you have the ability to control the receipt of that income, doing so before 2013 might save you tax in the long-run.

Gifting and charitable options
Donating assets to charity is one obvious way to reduce future investment income. Furthermore, options such as charitable lead trusts or charitable remainder trusts are additional vehicles for spreading your income over time and reducing your MAGI.

Gifting assets outright is another way to reduce your investment income. If you plan to leave money to your heirs, consider gifting assets to them now. For 2010, you can gift up to $13,000 to anyone without incurring gift tax.

While no one likes to pay taxes, it’s important to not let the tax tail wag the dog. All of these planning techniques are client-specific and should be discussed with your advisor to ensure they are the right fit for your long-term plan. And keep in mind that this surtax does not take effect until 2013. Between now and then, who knows what other legislative changes we might see.