The 2013 Medicare Surtax: What You Need to Know

The American Taxpayer Relief Act of 2012 and the Patient Protection and Affordable Care Act of 2010 have ushered in new income tax provisions which become effective in 2013.  One of the new provisions is the 3.8% Medicare surtax on an individual’s Net Investment Income.  This tax is one of the funding provisions for the new health care legislation, known as Obamacare.  The surtax will impact high income taxpayers who have a modified adjusted gross income in excess of specific thresholds.

FIRST OF ALL, WHO IS A “HIGH INCOME” INDIVIDUAL?  WILL I BE SUBJECT TO THIS TAX?

Individuals will be subject to the tax if they have any amount of net investment income and their modified adjusted gross income (“MAGI”) for the year is greater than the following threshold amounts:

  •   Married filing jointly                                              $250,000
  •   Married filing separately                                        $125,000
  •   Single or head of household                                   $200,000

HOW IS THE TAX CALCULATED?

The 3.8% tax is calculated on the lesser of (1) your net investment income or (2) your MAGI in excess of the threshold amount.  Some common types of investment income are: interest (excluding tax exempt interest), dividends, capital gains, rental income (if you are not a real estate professional) and passive income from partnership activities.

DOES THE TAX APPLY TO THE GAIN ON THE SALE OF MY PERSONAL RESIDENCE?  WHAT ABOUT A VACATION HOME OR INVESTMENT REAL ESTATE?

Net investment income only includes the net taxable gain from the sale of a personal residence, which is the gain in excess of $500,000 for married individuals and $250,000 for single individuals.    The entire net capital gain from the sale of a vacation home, investment property or rental real estate is included in investment income.

DOES THIS TAX APPLY TO TRUSTS?

The tax will apply to estates and trusts with undistributed net investment income and an adjusted gross income in the amount of $11,650 for 2013.

WHAT CAN I DO TO MINIMIZE THE IMPACT OF THE SURTAX?

The timing of transactions becomes a very important tax planning tool in avoiding or minimizing the impact of the 3.8% surtax.  This is especially true for sales transactions of stock, real estate and other investments.  The current year tax impact of net investment income and other gains and losses should be reviewed in order to minimize the tax.

Other potential opportunities to minimize the surtax impact are:

  • Consider converting traditional IRAs to Roth IRAs.  This would reduce the MAGI in future years when distributions are taken from the accounts.
  • Investing in tax exempt bonds instead of taxable bonds.  The interest from the tax exempt bonds is excludable.
  • Harvesting capital losses to offset capital losses to reduce net investment income and MAGI.
  • Managing retirement plan distribution to maintain MAGI under the threshold amounts.

IS THE 3.8% SURTAX ON NET INVESTMENT INCOME THE ONLY MEDICARE SURTAX?  WHAT ABOUT EARNED INCOME?

No, there is also a .9% Medicare surtax on the wages and self-employment income of high income taxpayers.  This tax applies to earned income in excess of $200,000 for single filers, $250,000 for married taxpayers filing joint returns and $125,000 for married taxpayers filing separately.

For more information regarding tax planning, tax compliance and controversy, estate planning, or business law,  please visit the Hoffman & Associates website at www.hoffmanestatelaw.com or call us at 404-255-7400 or send us an email.

In accordance with IRS Circular 230, this article is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose. The information contained herein is provided “as is” for general guidance on matters of interest only. Hoffman & Associates, Attorneys-at-Law, LLC is not herein engaged in rendering legal, accounting, tax, or other professional advice and services. Before making any decision or taking any action, you should consult a competent professional advisor.

What the New Tax Law Means to You

As you probably know, Congress avoided the so-called fiscal cliff by passing – at the 12th hour –the American Taxpayer Relief Act of 2012 (the 2012 Tax Act), signed into law by the President on January 2, 2013. The 2012 Tax Act makes several important revisions to the tax code that will affect estate planning for the foreseeable future. What follows is a brief description of some of these revisions – and their impact:

  • The federal gift, estate and generation-skipping transfer tax provisions were made permanent as of December 31, 2012. This is great news for all Americans; for more than ten years, we have been planning with uncertainty under legislation that contained built in expiration dates. And while “permanent” in Washington only means that this is the law until Congress decides to change it, at least we now have more certainty with which to plan.
  • The federal gift and estate tax exemptions will remain at $5 million per person, adjusted annually for inflation. In 2012, the exemption (with the adjustment) was $5,120,000. The amount for 2013 is expected to be $5,250,000. This means that the opportunity to transfer large amounts during lifetime or at death remains. So if you did not take advantage of this in 2011 or 2012, you can still do so – and there are advantages to doing so sooner rather than later. Also, with the amount tied to inflation, you can expect to be able to transfer even more each year in the future.
  • The generation-skipping transfer (GST) tax exemption also remains at the same level as the gift and estate tax exemption ($5 million, adjusted for inflation). This tax, which is in addition to the federal estate tax, is imposed on amounts that are transferred (by gift or at your death) to grandchildren and others who are more than 37.5 years younger than you; in other words, transfers that “skip” a generation. Having this exemption be “permanent” allows you to take advantage of planning that will greatly benefit future generations.
  • Married couples can take advantage of these higher exemptions and, with proper planning, transfer up to $10+ million through lifetime gifting and at death.
  • The tax rate on estates larger than the exempt amounts increased from 35% to 40%.
  • The “portability” provision was also made permanent. This allows the unused exemption of the first spouse to die to transfer to the surviving spouse, without having to set up a trust specifically for this purpose. However, there are still many benefits to proper estate planning using trusts, especially for those who want to ensure that their estate tax exemption will be fully utilized by the surviving spouse.
  • Separate from the new tax law, the amount for annual tax-free gifts has increased from $13,000 to $14,000, meaning you can give up to $14,000 per beneficiary, per year ($28,000 for a married couple) free of federal gift,  estate and GST tax – in addition to the $5 million gift, estate, and GST tax exemptions. By making annual tax-free transfers while you are alive, you can transfer significant wealth to your children, grandchildren and other beneficiaries, thereby reducing your taxable estate and removing future appreciation on assets you transfer. And, you can significantly enhance this lifetime giving strategy by transferring interests in a limited liability company or similar entity because these assets have a reduced value for transfer tax purposes, allowing you to transfer more free of tax.  Gifting to Family Trusts allows the tremendous advantage of gifting to one destination, while using the annual gift exclusions for all of your descendants.

For most Americans, the 2012 Tax Act has removed the emphasis on planning for worst case scenarios and put it back on the real reasons we need to do estate planning: taking care of ourselves and our families the way we want. This includes:

  • Protecting you, your family, and your assets in the event of incapacity;
  • Ensuring your assets are distributed the way you want;
  • Protecting your legacy from irresponsible spending, a child’s creditors, and from being part of a child’s divorce proceedings;
  • Providing for a loved one with special needs without losing valuable government benefits; and
  • Helping protect assets from creditors and frivolous lawsuits; and from estate depletion to fund nursing home costs.

For those with estates less than the $5.25 million exemption amount, trusts should still provide much valued asset protection.  However, those who are less concerned about asset protection may want to review options for unwinding previous transactions to the extent possible and, at a minimum, review their estate plan to ensure proper income tax planning (see below).

For those with larger estates, ample opportunities remain to transfer large amounts tax free to future generations, but it is critical that professional planning begins as soon as possible. With Congress looking for more ways to increase revenue, many reliable estate planning strategies may soon be restricted or eliminated.   REVENUE RAISING PROPOSALS INCLUDE 1) LIMITING THE BENEFITS OF GRANTOR TRUSTS, 2) LIMITING THE DURATION OF ALLOCATION OF GST EXEMPTION, 3) IMPOSING A MINIMUM 10 YEAR TERM FOR GRANTOR RETAINED ANNUITY TRUSTS (“GRATS”), AND 4) REDUCING THE AVAILABILITY OF ENTITY BASED VALUATION DISCOUNTS.  These are all tools that can reduce your estate tax exposure but that may not be available much longer.  Thus, it is best to put these strategies into place now so that they are more likely to be grandfathered from future law changes.

Further, as is well publicized, the 2012 Tax Act included several income tax rate increases on those earning more than $400,000 ($450,000 for married couples filing jointly).  Combined with the two additional income tax rate increases resulting from the healthcare bill, income tax planning for individuals is obviously now more important than ever.

What hasn’t been as publicized is that trusts (only those trusts not taxed as grantor trusts) and estates will be subject to these new taxes and higher tax rates on income above $11,950.   Proper income tax/distribution planning for trusts and estates will be essential going forward to minimize these burdensome tax increases.

Income tax basis planning will also be more important.  Many trusts hold highly appreciated, low tax basis assets. Reverse DGT transactions – purchasing low basis assets back from grantor trusts – can be used to obtain a step up in basis at death.  Trusts may be able to be amended and/or restated to allow a Trust Protector to identify low basis assets and take certain actions that would cause them to get a step up in tax basis at your death.   For assets not already in trust, Alaska Community Property Trusts can be utilized to get a double step up in tax basis at both spouse’s deaths.

The good news is that if you have been sitting on the sidelines, waiting to see what Congress would do, the wait is over.  We have increased certainty with “permanent” laws and you can have some comfort that the rules won’t drastically shift from year to year.  Unfortunately, for those of you with larger estates, planning techniques that can be utilized to reduce estate tax exposure are still on the chopping block – so don’t wait to plan.  For all clients, income tax planning, including income tax basis planning, should be a focus this year.  As always, the ultimate goals of estate planning, including protecting family assets and providing for loved ones, do not change.  Make sure you have a good plan to meet these goals. Schedule an appointment today by calling us at (404) 255-7400.

In accordance with IRS Circular 230, this article is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose.  The information contained herein is provided “as is” for general guidance on matters of interest only.  Hoffman & Associates, Attorneys-at-Law, LLC is not herein engaged in rendering legal, accounting, tax, or other professional advice and services.  Before making any decision or taking any action, you should consult a competent professional advisor.