Beginning this year, certain high-income individuals may be liable for a new 3.8% surtax on investment income. Unlike other tax changes for 2013 included in the American Taxpayer Relief Act of 2012 (ATRA), this provision was part of the Patient Protection and Affordable Care Act of 2010 (PPACA).
How it works: The 3.8% Medicare surtax applies to the lesser of your “net investment income” (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. For example, if you are a single filer with $150,000 in NII and a MAGI of $300,000 in 2013, the surtax is $3,800 (3.8% of $100,000 excess MAGI). Now that ATRA has increased the top income tax rate to 39.6% in 2013, you could pay a combined federal tax rate of 43.4% (39.6% + 3.8%) on certain income.
The PPACA definition of NII includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities, and income from the trading of financial instruments or commodities. But certain other items—such as wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a nonpassive business, and distributions from qualified retirement plans and IRAs—are excluded.
Depending on your situation, you might consider strategies designed to reduce exposure to the new surtax. Here are five possibilities.
- Municipal bonds: The income from tax-exempt municipal bonds does not count toward NII or MAGI. So adding municipal bonds (“munis”) to your portfolio—or increasing your current investment in munis—is often a good way to decrease liability for the 3.8% surtax. Of course, you do not want to go overboard with any one investment, so plan accordingly.
- Roth conversion: By converting funds in a traditional IRA to a Roth, you can seek tax protection in future years. For a Roth in existence at least five years, qualified distributions (e.g., those made after age 59½) are 100% tax-free. This avoids any surtax problem.
- Passive activities: NII includes amounts generated by passive activities such as rental real estate. Therefore, if you own a business interest where you do not take an active role, you might have to pay the surtax. However, if you “materially participate” in the business, the income generally will not count as NII. Caution: Special rules apply to rental real estate activities.
- Charitable remainder trusts: With a charitable remainder trust (CRT), you can generally claim a current tax deduction for the gift of the remainder interest, while receiving income for a period of years or your lifetime. The CRT can help avoid the surtax on highly appreciated capital gains. Obtain professional guidance for these trusts.
- Annuities: By investing in a tax-deferred annuity, you can arrange to receive payments in retirement, while “leapfrogging” high-income years when you might be liable for the 3.8% surtax. This tax-deferral strategy may be advantageous if you expect to be in a lower tax bracket in retirement than you are now.
Consider these five options, along with other alternatives, as part of a comprehensive tax plan for 2013. A Lohman Company professional tax advisor can lend assistance.