Upper-income taxpayers could face a potential tax nightmare in 2013 due to a new 3.8% Medicare surtax on net investment income.
Strategy: Wake up to reality. If you take tax action now, you might be able to reduce, or even eliminate, your liability for the new 3.8% surtax. However, if you wait until the end of the year, it may be too late.
Don’t think this surtax is small potatoes. When you combine it with the new top federal income tax rate of 39.6%, your effective top tax rate could be a whopping 43.4%. And, if you add in state and local taxes, more than half of your highest-taxed dollars could go to the authorities!
Here’s the whole story: Under a provision in the 2010 health care law, a 3.8% Medicare surtax applies to the lesser of your “net investment income” (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for unmarried filers and $250,000 for married joint-filing couples (see box).
For this purpose, NII is defined to include interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities and income from the trading of financial instruments or commodities. Certain other income items, such as wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a nonpassive business and distributions from qualified retirement plans and IRAs, are specifically excluded.
The surtax went into effect on Jan. 1, 2013, but you still have plenty of time to minimize the impact. Here are five tax-saving opportunities.
1. Add munis to your portfolio. The income from tax-exempt municipal bonds (munis) doesn’t count in the surtax calculation. Therefore, if you invest in munis, or expand your current investment in munis, you’re decreasing your exposure to the 3.8% surtax.
Tip: Don’t go overboard on any one investment. Consider all the risk factors.
2. Convert to a Roth. The payoff for converting a traditional IRA to a Roth IRA comes in the future. For a Roth in existence at least five years, qualified distributions, such as those made after attaining age 59½, are completely tax-free. But note that you’ll have to pay current tax on the conversion.
Tip: Although IRA distributions don’t count as NII in the surtax calculation, such distributions still push up your MAGI, which can increase your exposure to the surtax.
3. Become active in passive activities. NII includes amounts generated by passive activities like rental real estate. Thus, if you don’t take an active role in a business, you might owe the surtax. However, as long as you “materially participate” in the business, the income generally won’t count as NII. For instance, you qualify if you participate in the activity for more than 500 hours during the year.
Tip: The rules for rental real estate are even more stringent. We’ll have more on this in a future article.
4. Establish a charitable remainder trust. When you transfer funds to a charitable remainder trust (CRT), you can claim a current tax deduction for the gift of the remainder interest to the charity, while continuing to receive income for a term of years or your lifetime. In the meantime, capital gains and other income realized by the CRT are sheltered from the 3.8% surtax.
Tip: The transfer to a CRT also shelters the funds from estate tax.
5. Leapfrog into the future. If you invest in a tax-deferred annuity, you can receive payments in retirement, when you would expect to be in a lower income tax bracket than you are in your main working years. Thus, the annuity helps you to “leapfrog” the highest taxed years when the 3.8% surtax is likely to apply.
Tip: Conversely, an annuity may not make sense if you anticipate being in a higher tax bracket in retirement than you are now.
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