Financial Steps to Take Now to Prep for Looming Tax Increases

Have you heard the one about the three wise men (or women) in Washington, D.C.?

Me neither. Looks like the joke’s on us.

As a result of political gridlock, a slew of tax laws will expire at the stroke of midnight on Dec.31 if Congress is not able to come to agreement about the fiscal cliff and our nation's budget. If no agreement is reached, some tax rates could go up to levels not seen since the late 1970s and early 1980s.

Although there are just five weeks before the end of the year, there’s a chance both political parties will agree on at least a temporary fix so that businesses and individuals would have some idea of what’s in store for their taxes next year and and plan accordingly. But I’m not holding my breath.

Moreover, if you have the misfortune of earning an income amount that Washington has arbitrarily declared deems you “rich,” you might not want to wait until the last days of the year to get your affairs in order. That’s because regardless what happens to income tax and capital gains tax rates, the 3.8% Medicare surtax is about the only tax change you can count on-- it is locked and loaded and headed your way on Jan. 1.

Surtax Sir? Madam?

The Affordable Care Act actually includes two surtaxes. One is a 0.9% additional tax that is applied to earned income; the other is a 3.8% additional tax on investment income. Each is computed separately.

Let’s take the 0.9% surtax on earnings. This kicks in when your income from a job exceeds a certain amount. If you are single, the threshold is $200,000 and $250,000 for married taxpayers who file a joint return. (You don’t have to be a mathematical genius to notice the “marriage penalty” inherent in this.)

Wages have been subject to a 2.9% Medicare tax for years: The amount is split, with the employee and employer each paying half, or 1.45%. (1) Starting with your first paycheck in 2013, if your annual salary exceeds the threshold, you will pay 2.35% toward Medicare. There is no increase in the amount employers have to pay.

When the Bush-era tax reductions expire on Jan. 1, the top marginal income tax bracket will revert to 39.6%. With the addition of the surtax, this jumps to 40.5% for individuals whose earned income exceeds the threshold.

On the other hand, since the 0.9% surtax only applies to wages, retirees and others who do not receive income from a job don’t have to worry about this additional tax, no matter how much income they receive from other sources.

Investor Beware

The 3.8% surtax is a game-changer. It marks the first time that Medicare tax will be assessed on investment income. To determine if you’ll be affected, you need to know your “Modified Adjusted Gross Income,” or MAGI. (2)  As defined for the purposes of this law, MAGI is your Adjusted Gross Income (AGI) plus any net foreign income that you excluded.

Translation: unless you work outside the United States, MAGI = AGI. In addition, “net investment income” is one of the items included in your AGI.

Now here’s where it gets tricky: The additional 3.8% tax is only triggered if your MAGI is higher than the applicable threshold- $200,000 (single) or $250,000 (married filing joint). If this is the case, then the surtax is assessed on either your “net investment income” (gains minus losses), or the amount by the which your MAGI exceeds the threshold amount- whichever is smaller.

Thus, there are two basic strategies avoid this tax, either: a) keep your MAGI below the threshold, or b) eliminate all investment income. If you don’t have any investment income, you won’t be subject to this tax even if your job pays a million bucks a year. (3)

It’s important to understand what’s meant by “investment income.” This includes:

• Interest, Dividends, Royalties, Annuities and Rents
• Capital Gains- including any profit you make on the sale of your residence if it exceeds the amount you are allowed to exclude(4) 
• Passive Activity Income

It does not include:

• Income from a business in which you are an active participant
• Distributions from an IRA or qualified retirement plan
• Gain on the sale of an active interest in a partnership or S-Corp
• Gain inside a tax-deferred annuity
• Distribution from a tax-free Roth account
• Interest from tax-exempt municipal bonds (Note: Obama has proposed changing this.)

Although not considered investment income, some of the above items can add to your MAGI and, thus, could make you subject to this tax by pushing you over the threshold.

CPA Robert Keebler, in Green Bay, Wisc., has been writing about and holding nationwide seminars on the implications of this law for more than a year, and provides the following examples to help taxpayers figure what these changes mean for them:

A) John is single. He has $100,000 in salary and $50,000 in net investment income. MAGI = $150,000. Result: No surtax. MAGI is below $200,000 threshold.

B) Mary is single. She has $225,000 of net investment income and no other income. MAGI = $225,000. Result: 3.8% surtax applies to $25,000 (lesser of MAGI over threshold or net investment income).

C) Scott and Sarah (married, filing joint) have $205,000 in salaries plus $80,000 of net investment income. MAGI = $285,000. Result: 3.8% surtax applies to $35,000 (lesser of MAGI over threshold or net investment income).

D) Art and Patricia (married, filing joint) have pension income of $130,000 and net investment income of $115,000. MAGI = $245,000. Result: 3.8% surtax does not apply. MAGI is below threshold.

E) Same facts as in “D” except that Art and Patricia have to take required minimum distributions from their traditional IRAs totaling $50,000. MAGI = $295,000. Result: 3.8% surtax applies to $45,000 (lesser of MAGI over threshold or net investment income).

But Wait! There’s More

Of course, the Medicare surtax isn’t the only thing to worry about. As I wrote in last week’s column a host of common tax rates and tax breaks are set to expire soon. For instance, the top long-term capital gains tax rate will jump to 20% next year from 15% where it’s been for more than 10 years. Tack the 3.8% surtax on that and you’re at 23.8%.

If you’re retired and living on dividends, those will once again be taxed as ordinary income. In other words, instead of paying a maximum of 15% in tax, you could be looking at 43.4%- that’s nearly triple the tax rate you’ll pay this year.

Here are some strategies to discuss with your tax and financial advisors:

1.) Sell appreciated assets this year while the maximum long-term capital gains rate is 15%.

2.) Consider converting some or all traditional IRAs to a Roth while the top ordinary income tax rate is 35% instead of 43.4%.

3.) Shift some of the investments in your taxable portfolio into tax-sheltered and tax-exempt vehicles such as annuities, life insurance and municipal bonds.

4.) Plan to max out your contributions to retirement plans next year; whatever you contribute escapes income tax (for now) and all gains are tax-deferred. (If you are self-employed or own a small business, a defined benefit plan might be attractive because of the larger, deductible contribution allowed.)

5.) Trust income is also subject to the 3.8% Medicare surtax, but at a much lower threshold: $11,650 (based on 2012 figures). If you are the administrator or beneficiary of a trust, discuss the possibility of shifting the asset mix to reduce this exposure.

6.) If possible, accelerate income into this year and defer deductions into 2013.

7.) Either accelerate installment sale income into this year, or spread it out longer to reduce the annual payment so that your MAGI remains below the threshold.

8.) Consider oil and gas investments which offer and immediate deduction of up to 95% of your original investment (Keebler).

9.) Certain types of real estate investments provide a deduction for depreciation, reducing your taxable income.

1. Self-employed individuals currently pay both halves of the tax, or 2.9%.

2. MAGI has different definitions depending upon the law involved. In this case, it is defined as your AGI, plus any foreign income that you were able to exclude.

3. In this case your net investment income = $0. This is clearly less than the amount by which your MAGI exceeds the threshold ($800,000 if you’re single; $750,000 if married, filing joint). Thus the 3.8% surtax would be assessed against $0 for a tax of $0.

4. $250,000 if you are single; $500,000 if you are married.

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.