New 3.8% Medicare Tax

Will You be Subject to the New 3.8% Medicare Tax

on Investment Income?

August 22, 2012



To Our Valued Clients and Friends:



The health care reform act imposes a new 3.8% Medicare tax on the investment income of higher-income individuals. Since this tax takes effect in 2013, it is not too soon to examine methods to lessen the impact of the tax by doing some investment planning during these last five months of 2012.


Thresholds and impact. The tax applies to the lesser of net investment income or modified adjusted gross income (MAGI) above the following thresholds:


• $200,000 for individuals and heads of household

• $250,000 for joint filers and surviving spouses

• $125,000 for married filing separately

• $11,200 for estates and trusts (undistributed income)



Net investment income. Net investment income includes interest, dividends, annuities, net passive rents and royalties, and other gross income from a passive activity. Capital gains income will be subject to the tax including gain from the sale of investment property. Taxable gains from the sale of a principal residence, and gains from the sale of a vacation home will also be subject to the tax. The tax does not apply to nontaxable income, such as tax-exempt interest or veterans' benefits.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property's basis. It also puts the focus on investment expenses that may reduce net gains such as interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers' fees, may increase basis or reduce the amount realized from an investment. As such, you may want to consider avoiding installment sales with net capital gains (and interest) running past 2012, or consider electing out of existing installment sales to avoid paying the 3.8% tax in the future.

Exceptions. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. The exception for distributions from retirement plans suggests that potentially taxed investors may want to shift wages and investments to retirement plans. Increasing contributions will reduce current income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, and should consider increasing their contributions to existing plans.

Another exception includes income from a trade or business that is not a passive activity, such as a sole proprietorship. Investment income from an active trade or business is also excluded; however, income from trading in financial instruments and commodities is subject to the tax. The tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity's property would be from an active trade or business. The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable.

The new Medicare tax can have a substantial impact if you have income above the specified thresholds. Also, don't forget that, in addition to the tax on investment income, you may face other tax increases proposed by the Obama administration that could take effect in 2013:


• The top two marginal income tax rates on individuals would rise from 33% to 36% and 35% to 39.6%.

• The maximum tax rate on long-term capital gains would increase from 15% to 20%.

• Qualified dividends, currently capped at the 15% long-term capital gain rate, would be taxed as ordinary income.


Congress may step in and change these rate increases, but the possibility of rates going up for upper income taxpayers is sufficiently real that tax planning must take them into account.



Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.

Sincerely,

The HSA Team