Tips for Beating the Medicare Surtax

Starting next year, as part of the Affordable Care Act, taxpayers deemed to be “wealthy” will be hit with an additional 3.8% surtax to cover the cost of sky-rocketing Medicare coverage. This might include you if your modified adjusted gross income (MAGI) exceeds $200,000 and you are unmarried or $250,000 and you file your federal income tax return as “married/joint.” (1)

MAGI includes earnings from a job, pension income and withdrawals from retirement plans such as a 401(k) or traditional IRA. You further “modify” this amount by adding back any deduction you took for net foreign income. MAGI also includes net investment income- income earned on investments minus any loses.

As critics have pointed out, the thresholds impose a “marriage penalty” to the tune of $150,000. That is, two unmarried, but co-habiting individuals who each earned $200,000 would escape this surtax completely even though their joint household income was $400,000. On the other hand, a married couple would get hit with the 3.8% tax at the substantially-lower income level of $250,000.

The thresholds also punish taxpayers who live in expensive areas of the country, like Southern California, Manhattan or Washington, D.C., where above-average incomes are essentially required in order to pay for a rather modest lifestyle- especially if you’ve kids.

The tax also hits individuals who receive a significant portion of their income from investments- stock dividends, capital gains (such as from the sale of securities or your home), bank interest, rental income, royalties and income from annuities. All of the above are considered sources of “unearned income.”

But if you understand how the law is worded, there are steps you can take to reduce or entirely escape the surtax regardless of your tax bracket. It comes down to carefully arranging the sources of your income.

According to the  legislation, the 3.8% additional tax is applied to either the net amount of taxable investment income or the amount of MAGI that exceeds the threshold- whichever is LESS. (2)

Many tax professionals are just beginning to appreciate the implications of this legislation; they didn’t want to waste time studying a law that could be struck down as unconstitutional. Professionals have  been scrambling to catch up ever since the Supreme Court issued its decision upholding the reform last month.

Certified Public Accountant Robert Keebler has been warning about the tax consequences of this law since last year. Keebler, who holds a Master of Science degree in taxation, operates a private practice in Green Bay, Wisc., and addresses tax professionals at conferences around the country. The following is adapted from a handout he provides to attendees at his seminars:

Jeannette and Russ have $300,000 in salaries and $30,000 in net investment income consisting of stock dividends and interest on bank accounts & CDs. They file their taxes as “married/joint.”

Net investment Income:        $30,000

MAGI ($300,000+$30,000):  $330,000

Threshold for Married/Joint:   - 250,000

Excess MAGI over threshold:   $80,000

Since $30,000 is less than $80,000, Scott and Sarah will pay a surtax of 3.8% on their net investment income: 3.8% x $30,000 = $1,140 in additional federal income tax.

Now, watch what happens when Jeannette and Russ switch their investments and move the proceeds into municipal bonds:

Net Investment Income:                  $0

MAGI ($300,000+$0):        $300,000

Threshold for Married/Joint:  $250,000

Excess MAGI over threshold:    $50,000

The interest on municipal bonds is not subject to federal income tax, so there is no taxable investment income from these. Since $0 of net investment income is the lesser amount, this is what the surtax is based upon: 3.8% x $0 = $0. Jeannette and Russ will avoid the surtax completely!

An added bonus is that the average yield on Aa-rated municipal bonds is currently 4.39% while the national average on one-year CDs is 0.30%. As a result, Jeannette and Russ’ total after-tax income will actually be higher.

Of course, you need to be mindful of early cancellation fees on CDs and transaction fees on the sale of securities. It’s a good idea to consult with your tax and investments professionals before you make any major moves. None-the-less, over ten years Jeannette and Russ would save $11,400 in taxes by using this strategy. If they wanted to keep some assets invested in dividend-paying stocks, they could use their IRAs or company-provided retirement plans for this purpose. Income and capital gains on these accounts are either tax-deferred or, in the case of Roth accounts, tax-free.

(1) If you file “married/separate” the threshold is $125,000 per person.

(2) Chapter 2A of the Healthcare Act states: IN GENERAL.—Except as provided in subsection (e)—

‘‘(1) APPLICATION TO INDIVIDUALS.—In the case of an individual, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax equal to 3.8 percent of the lesser of—‘‘(A) net investment income for such taxable year, or ‘‘(B) the excess (if any) of— ‘‘(i) the modified adjusted gross income for such taxable year, over ‘‘(ii) the threshold amount.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. 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. 

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