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New 3.8% Medicare Surtax Spurs Year-End Action

No one ever said year-end tax planning in 2012 would be easy. For starters, the elimination of the “Bush tax cuts” will result in higher federal tax rates for income, capital gains, and dividends, beginning in 2013 (unless Congress enacts new legislation). But there’s another major tax change in store for next year: a new 3.8% surtax that will hit some high-income investors.

The 3.8% Medicare surtax applies to the lesser of your “net investment income” or the amount by which your modified adjusted gross income (MAGI) exceeds either $200,000 for single tax filers or $250,000 for joint filers. Net investment income includes interest, dividends, royalties, rents, gains from sales of property (other than property held in an active trade or business), and income from passive activities, but not tax-exempt interest or distributions from IRAs and qualified retirement plans.

Facing this prospect, high-income investors may want to take steps before the end of this year to reduce the sting of the surtax next year. Here are several ideas to consider:

  • Sell assets soon or hold on. If the law doesn’t change before 2013, you might decide to sell stocks, rental real estate, or other assets in 2012. That will help you avoid both the higher tax rates on capital gains and the 3.8% surtax that will kick in next year. Of course, any asset sale also needs to make sense from a financial perspective. If you decide to hold on to most of your investments for now you could still sell them later during a year in which your income is relatively low (and you’ll be in a lower tax bracket).
  • Sell property on an installment sale basis. Alternatively, if you’ve decided to sell property such as rental real estate and you have a good offer in hand, you might arrange an installment sale. As the name implies, the buyer will make regular payments over two or more years. (Most buyers will agree to this gladly.) By paying capital gains tax only on the portion of the payment you receive during a particular year, you’ll spread out the tax liability and you may be able to stay below the threshold for triggering the 3.8% surtax.
  • “Hide” income in IRS-approved tax shelters. It’s a myth that there are no more tax shelters. For instance, if you invest in life insurance or annuities, you don’t owe any current tax on the funds building up in your account. Life insurance proceeds aren’t paid until the insured person dies, while a deferred annuity may let you “leapfrog” your high-income years and receive taxable distributions when you’re earning less. Also, income from municipal bonds is completely free of federal income tax. Other investment opportunities, such as rental real estate and oil gas and deals, may provide tax breaks that reduce net investment income for purposes of the 3.8% surtax.
  • Convert to a Roth IRA. The usual payoff for converting funds in a traditional IRA to a Roth is that future distributions can be 100% tax-free. But you have to pay current tax on the value of the assets you move into the new account. By converting before the 3.8% surtax hits in 2013, you can reduce the overall tax bite. Or you could decide to make the conversion over several years to minimize the effect on your income (and your tax rate).
  • Establish a charitable remainder trust (CRT). A CRT lets you transfer assets to a trust that eventually will benefit a designated charity—and that will, in the meantime, provide income to a beneficiary you designate. The beneficiary receives income from the assets over the trust term, thereby spreading out the tax liability and reducing the likelihood that the beneficiary will be subject to the surtax. When the term expires, the remainder goes to the charity. Just keep in mind that this is a complex arrangement that needs to be considered as part of your overall estate plan.
  • Put family members on the payroll. Remember that “net investment income” includes income from sales of passive investments—but not from property that’s part of an active trade or business. By hiring younger family members to work for your firm, you can significantly reduce their “net investment income” for the surtax calculation. The savings can be enormous for those involved with highly valued businesses. Of course, the family members must perform bona fide duties.

These are just several ideas for minimizing the impact of the 3.8% Medicare surtax. We can work with your tax advisor and your attorney to help you plan steps that make sense in your situation.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.


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