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In some respects you should want your taxes to go up next year and every year if it reflects higher income. As a rule of thumb, for every dollar your federal income tax goes up your income will have gone up three to four dollars. To quote Jimmy Fallon in a currently running TV commercial, who wouldn’t want more money? But it is frustrating (to understate it) when your taxes go up without an increase in your income. That is the fate that will befall many next year as the revenue raising portion of the Health Care Act kicks in…but there are ways to mitigate it. Whatever other changes Congress has up its sleeve in either direction (which means even more in a Presidential election year) we know that 2013 will begin with two additional tax raisers. There is the additional 3.8% surtax on certain types of investment income and gains (Code section 1411), and the additional .9% Medicare tax for certain earned income (not to mention the excise tax on those without health insurance and on those with too much health insurance…I mean that…I am not mentioning these in this article). If you wish to view this tax as rational, then the way to explain it is to see it as a way to increase the Medicare contribution made by some higher income taxpayers by either subjecting investment income (i.e. income on capital), currently not subject to the Medicare portion of FICA, to that tax or by increasing the existing Medicare tax on earned income (i.e. income from labor) for those same taxpayers. ADDITIONAL INVESTMENT INCOME TAX There are three concepts you need to get a handle on. · The first concept is “Modified Adjusted Gross Income” or MAGI for short, although this is one MAGI that bears no gifts. For the most part this really just means adjusted gross income; the modification to which it refers relates only to those American taxpayers working overseas who are permitted to exclude from income up to $92,900 (as of 2011). For those working overseas taking this exclusion a portion is added to AGI; for those not working overseas MAGI is just your AGI. · The second is the “threshold amount.” This is the key number; if a taxpayer exceeds this threshold then they are subject to this tax on their net investment income (the third component). If you are single your threshold amount is $200,000. If you are married filing jointly your threshold amount is $250,000. If you are married filing separately it is $125,000. Trusts are also subject to this; the threshold amount for a trust is $12,000. For the rest of this article to make it easier to write and to read I am assuming that all taxpayers are married filing jointly and the $250,000 is the threshold to work with. Put another way, if a couple’s joint MAGI is less than $250,000 they do not incur this tax.
· The last critical concept is “net investment income” (“NII”): o interest, dividends, annuities, rents and royalties not derived from a business, less allocable expenses; o income from a passive activity; o income from a business engaged in trading financial instruments or commodities (the infamous carried interest); o net gain from the disposition of property (other than active business property) and from trading in financial instruments and commodities; - this includes the gain from the sale of a residence but only to the extent the gain exceeds the section 121 exclusion (the exclusion for those who qualify is currently $500,000 for a married couple filing jointly and $250,000 for all others). Now that you have a firm grasp on these three concepts you can master the tax computation. This involves three steps: · first, what is the net investment income; · second, how much does the MAGI (basically AGI) exceed the applicable threshold amount; · finally multiply the smaller of these two numbers by 3.8% and you have the tax. Let’s take some examples (all married filing jointly, living and working in the US and no negative adjustments): 1. Amy and Abe have $200,000 salary income and no investment income. a. $200,000 MAGI – $250,000 threshold = 0 b. NII = 0 c. No additional tax 2. Barb and Bob have no salary income and $200,000 investment income a. $200,000 MAGI - $250,000 threshold = 0 b. NII = $200,000 c. The smaller number is 0, so no additional tax 3. Ceil and Cecil have $500,000 salary income and no investment income a. $500,000 MAGI - $250,000 threshold = $250,000 b. NII = 0 c. The smaller number is 0, so no additional tax 4. Donna and Don have no salary income and $500,000 investment income a. $500,000 MAGI - $250,000 threshold = $250,000 b. NII = $500,000 c. The smaller number is $250,000, so 3.8% surtax is $9,500 on top of their income tax 5. Erin and Eddie have $125,000 of IRA distributions and sold for $950,000 the house they bought years ago for $200,000. a. Taxable Gain on the sale of the residence is $250,000 ($950,000 sale price - $200,000 cost basis - $500,000 home sale exclusion), plus $125,000 IRA distribution = $325,000 MAGI b. NII = $250,000 (the taxable gain in the sale of the residence) c. The smaller number is $250,000, so 3.8% surtax is $9,500 on top of their income tax 6. Millie and Mitt have $2,200,000 of earned income from carried interests and another $4,000,000 of dividends and net trading gains, plus Millie has a salary of $45,000 as a nurse. a. $6,245,000 MAGI - $250,000 threshold = $5,995,000 b. NII = $6,200,000 c. The smaller number is $5,995,000, for a 3.8% surtax of $227,810. Planning for this tax involves both knowing how the tax works and knowing what it does not apply to. For instance, as we approach 2013 it might make sense for those with substantial gains in the investment portfolios to sell those positions and shortly thereafter reacquire them, thereby beginning 2013 with a higher basis and lower potential gain subject to the surtax. But this of course accelerates recognition of this gain and might make sense only if the alternative would have been to sell during 2013 or even 2014 given the time value of money. Other ideas are based in understanding what is excluded from the surtax; these include: · Distributions from retirement plans, such as a 401(k), 403(b) and pension plans and IRAs (Roth or original recipe); · Tax exempt interest; · Inside gains within cash value life insurance as well as life insurance proceeds; · Active business income. So what does this mean? · Favor investing through an IRA and or other qualified plan and income deferral program since distributions from such a program is not NII, although it is included in MAGI. A Roth IRA and Roth 401(k) is even better than a regular IRA and 401(k) since Roth IRA distributions are not only excluded from NII but also from MAGI, so consider the value of converting the IRA to a Roth IRA in 2012. · Tax exempt bonds become more attractive relative to taxable investments than they have been. One in the 35% tax bracket in 2012 looks at a tax exempt bond as equivalent to a taxable investment of 6.15%; in 2013 that person is now functionally in the 38.8% bracket for these purposes and will see that 4% bond as equivalent to a taxable investment of 6.53%. · Charitable Lead and Charitable Remainder Trusts are worth a look. · Cash value life insurance becomes more attractive as a component of one’s investment portfolio. · It may make sense to aggregate the activities of several previously independent real estate ventures to achieve active status rather than passive status, but be careful to weigh this against the possibility of becoming subject to self employment tax. · Be careful when disposing of a pass-through business that has both active and passive components and allocating basis and fair market values accordingly, with the gain only from the passive portion attracting the 3.8% surtax. ADDITIONAL MEDICARE TAX Had enough? Congress is not done yet with you. If you are above the threshold for the 3.8% surtax, you are also in the increased Medicare tax zone. The Medicare portion of FICA is currently 2.9%, with 1.45% coming from the employer and 1.45% coming from the employee. Self employed individuals pay the entire 2.9%. With 2013 comes a rate increase of .9% on the employee portion, meaning that employees over the threshold will pay 2.35% and self employed individuals will pay 3.8%. Starting to see a pattern? The good news, if you can call it that, is that the surtax on investment income and the Medicare tax on earned income are mutually exclusive: any particular portion of a taxpayer’s income is subject to only one, not both.
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David S. Neufeld, Shareholder, Flaster Greenberg PC
1810 Chapel Avenue West | Cherry Hill, NJ 08002 856.382.2257 | david.neufeld@flastergreenberg.com Internationally Recognized Tax and Estate Planning Attorney |