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Navigating health reform
Affordable Care Act Impacts Everyone’s Tax Return
The recent United States Supreme Court ruling on the 2010 Patient Protection and Affordable Care Act (PPACA), legislation means health reform will move forward, and four tax increases will remain in the law for 2013. Several can impact all 1040 filers, while two affect those whose income exceeds $200,000 (single filers) or $250,000 (joint filers).
Contribution cap on health care FSAs
Presently, those employees who have an employer-sponsored “cafeteria” plan may contribute on a pre-tax basis to their health flexible spending account (FSA) through a salary reduction. The annual funding is currently unlimited for health costs under these Section 125 plans unless the employer has imposed a contribution limit on its employees.
Beginning in 2013, the PPACA places a cap of $2,500 on the amount that employees can annually contribute into their FSAs for health expenditures. This will impact those who use these accounts for planned medical costs that are not covered by other insurance, such as eye surgery or major dental work. (This contribution limit does not apply to FSAs used for dependent day care.)
Increased floor on medical deductions
Individuals may claim medical expenses as an itemized deduction in their Form 1040, but only to the extent the current year expenses exceed 7.5 percent of adjusted gross income (AGI) (the bottom line income on page one of Form 1040).
Beginning in 2013, this threshold increases to 10 percent of AGI. For example, for a Form 1040 reporting $100,000 of AGI, it will now take over $10,000 of out-of-pocket medical expenses to have any deductible amount. Prior to 2013, any medical costs of more than $7,500 would have been deductible in this example.
A transition rule provides relief through 2016 if either the taxpayer or the taxpayer’s spouse has attained age 65 by the close of the tax year. In that case, the former 7.5 percent threshold applies. However, beginning in 2017, the 10 percent threshold applies, as it does for all other taxpayers.
Medicare surtax on earned income
Presently, the Medicare tax applies to all wages and self-employment income. For wage earners, both the employer and the employee pay 1.45 percent, whereas a self-employed taxpayer pays the entire 2.9 percent.
Beginning in 2013, the PPACA imposes an additional 0.9 percent Medicare surtax, but only on higher income households. The tax applies to wage and self-employment income in excess of $200,000 for a single person’s or $250,000 for the combined wage and self-employment income of a married couple.
“There is no employer match on this new 0.9 percent tax,” notes Ben Darwin, a private client tax partner with CliftonLarsonAllen. “This tax is entirely paid by the employee or the self-employed individual. If you are self-employed, you will need to build this into your quarterly tax estimates beginning in 2013. And many two-earner joint filers may be surprised at 1040 filing time to find they had less withheld than their combined 0.9 percent tax.”
|Example: Medicare Surtax and Insufficient Withholding|
|Assume a married couple has combined salaries of $350,000, with one earning $200,000 and the other $150,000 in 2013. Neither will have any withholding for the new 0.9 percent Medicare surtax because neither exceeds the $200,000 threshold. However, in filing their Form 1040 for 2013, the combined salary income that exceeds the $250,000 threshold ($100,000 in this case) is subject to the 0.9 percent tax. That tax of $900 ($100,000 x 0.9 percent) is remitted with their 2013 Form 1040.|
Net investment income tax
Beginning in 2013, higher-income earners with net investment income will be subject to a 3.8 percent tax on the lesser of two amounts:
- Net investment income, or
- The excess of the taxpayer’s modified adjusted gross income (MAGI) above $200,000 (single filer) or $250,000 (joint filer)
If the taxpayer’s current income exceeds the $200,000/$250,000 threshold, the excess becomes a limitation on the amount of net investment income exposed to the tax. For example, if a joint return has modified adjusted gross income of $260,000, the $10,000 excess is the most that can be exposed to the net investment income tax, even if actual investment income far exceeds this amount. Net investment income includes three broad categories:
- Interest, dividend, annuity, royalty, and rental net income
- Net income from a business in which the taxpayer does not materially participate, and business income from trading and financial instruments or commodities
- Capital gains and other net gains from the sale of property
|Most investment income categories are exempt from the tax if they are derived from a business activity in which the taxpayer materially participates, other than trading and financial instruments and commodities. Similarly, any income subject to the self-employed Social Security tax is excluded. Also, tax-exempt interest income, retirement plan distributions, and tax-free gains from a principal residence are not exposed to this new tax.|
“This 3.8 percent tax impacts most capital gains and rental income, but also reaches partnership and S corporation income from a business in which the owner is not personally active,” says Kara Kessinger, CliftonLarsonAllen’s Northeast private client tax leader. “If you have a large capital gain transaction in the works, it may make sense to accelerate the gain into 2012 and avoid this 2013 tax.”
|Example: Tax on Net Investment Income|
|A retired couple reports a $300,000 capital gain from the sale of rental property, and $50,000 of other non-investment income (retirement plan payouts and taxable Social Security benefits). Accordingly, their total AGI in 2013 is $350,000. The 3.8 percent investment income tax applies to the smaller of the $300,000 of investment gain or the excess of total income over the $250,000 threshold. Total income of $350,000 is $100,000 over the threshold, and this amount is smaller than the investment capital gain of $300,000. Therefore, this couple will pay $3,800 of investment income tax in 2013 (3.8 percent x $100,000).|
High income thresholds
Both the 3.8 percent investment income tax and the 0.9 percent Medicare tax on earned income use a $200,000 single or $250,000 joint threshold. However, the 0.9 percent Medicare surcharge focuses only on the wage and self-employment income, while the 3.8 percent tax focuses on total tax return AGI. “Taxpayers who have income nearing these thresholds in 2013 or after will need to factor in these two new taxes,” says Darwin. “Even those who normally report income below these amounts may have a year with a large gain from the sale of a security or other investment, and that could mean a 3.8 percent tax on investment income.”
If income is at or near these thresholds, the focus should be on maintaining consistency from year to year so as to stay beneath the thresholds. Spikes in income from large individual retirement account (IRA) withdrawals, employment bonuses, and substantial capital gain recognition can trigger these taxes.
People who recognize a significant investment real estate sale or closely held corporate stock sale will want to consider using an installment arrangement to spread the income over multiple years, in order to stay below the threshold of the 3.8 percent tax. Those whose employment includes stock option opportunities often trigger high salary years when options are exercised, and those employees will now face the added 0.9 percent Medicare tax.
For people contemplating a large capital gain transaction in the next months, closing that sale within 2012 will insure that these taxes are not in play. As a general rule, large capital gain recognition is often postponed until January of the subsequent year to defer payment of the tax. But with these new taxes coming in 2013, taxpayers will want to consider closing major gain transaction within 2012.
“Taxpayers acting in 2012 will not only avoid the new 3.8 percent tax,” says Kessinger, “they will also avoid the threat of increased regular income tax rates that are in President Obama’s budget proposals for 2013.”
How we can help
These taxes add a significant cost to large capital gain recognitions (except those from an active pass-through business), and also affect rental income, bonuses, and other passive investment income. Consult your CliftonLarsonAllen tax advisor to help you interpret the application of these taxes to your situation, and discuss possible strategies to minimize the cost.