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Plan for High Income Surtaxes in 2013
The 2010 health care legislation brings a tax increase into play in 2013 that includes a 3.8 percent tax on net investment income, and a 0.9 percent Medicare tax on earned income. Generally, if your income exceeds $200,000 (single filing), or $250,000 (joint filing), you are at risk for these new taxes.
3.8 percent net investment income tax
Beginning in 2013, higher income individuals with net investment income will be subject to a 3.8 percent tax of the lesser of two amounts:
- Your net investment income, or
- the excess of the taxpayer’s modified adjusted gross income over a $200,000 (single) or $250,000 (joint filers) threshold amount.
If the taxpayer’s adjusted gross income is greater than the $200,000/$250,000 threshold, the excess becomes a limitation on the amount of net investment income exposed to the surtax. For example, if a joint return has a modified adjusted gross income of $260,000, the $10,000 excess becomes the limitation.
Net investment income includes three broad categories:
- Interest, dividends, annuities, royalties, and rents
- Income from a business in which the taxpayer does not personally, 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 in financial instruments and commodities).
Similarly, any income subject to the self-employed Social Security tax is excluded, as is tax-exempt interest income, retirement plan distributions, and tax-free gains from a principal residence.
“This 3.8 percent tax impacts most capital gains, rental income, and other flow-through income from a business in which the owner is not personally active,” says Nick Houle, a partner with CliftonLarsonAllen Wealth Advisors, LLC. “If you have a large capital gain transaction in the works, it may make sense to accelerate the recognition into 2012 and get ahead of this 2013 tax.”
Medicare surcharge tax 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 health care legislation imposes an additional 0.9 percent surtax — but only on higher income households. The tax applies to income in excess of:
- A single person’s wage and self-employment income over $200,000, or
- the combined wage and self-employment income of a married couple exceeding $250,000.
“There is no employer match on the 0.9 percent,” says Chris Hesse, a tax partner with CliftonLarsonAllen. “This tax is entirely paid by the employee or the self-employed individual. There will be employer withholding, but if you are self-employed, you will need to build this into your quarterly tax estimates. And some joint filers will have less withheld than their combined 0.9 percent tax.”
Higher income thresholds
While both taxes only impact high income earners, the threshold for the 3.8 percent tax focuses on total income in the tax return (technically “modified adjusted gross income,” which is generally the total income on page 1 of Form 1040). On the other hand, the 0.9 percent Medicare surcharge focuses only on the wage and self-employment earned income of the taxpayer. In both cases, the new taxes only apply to the investment income or earned income that is in excess of the thresholds.
Example – 3.8 percent tax on net investment income
A retired couple reports a $300,000 capital gain from the sale of a rental property (this is investment income) and $50,000 of other non-investment income (such as pension payments and taxable Social Security benefits), making their total AGI $350,000 in 2013. The 3.8 percent tax applies to the smaller of the $300,000 of investment income, or the excess of total income over the $250,000 threshold. Total income of $350,000 is only $100,000 over the threshold, so this couple will pay $3,800 of new tax (3.8 x $100,000).
Example – Medicare surtax on earned income
Assume a single taxpayer has wages or self-employment earnings of $500,000 in 2013. Previously, the 2.9 percent Medicare tax would have applied to the entire amount. Beginning in 2013, an additional tax of 0.9 percent is applied to the $300,000 portion that is in excess of the $200,000 threshold, causing an additional $2,700 of Medicare tax.
“Taxpayers who have a high income year in 2013 or after will need to factor in these two new taxes,” says Hesse. “Even those who are normally reporting income under the thresholds can have that one year with a large gain, such as from the sale of a business or an investment, and incur the 3.8 percent tax on any investment income.”
Many taxpayers will maintain income below the $200,000 single or $250,000 joint thresholds of these new taxes, and not incur either tax. However, if your income is at or near these thresholds, the focus will be on maintaining a consistency in their reportable income from year to year so as to stay beneath the thresholds. Spikes in income from large IRA withdrawals, bonuses, and substantial capital gain recognition, can trigger these taxes.
Using an installment sale to shift a large capital gain from an investment into multiple tax years could help you stay beneath the threshold of the 3.8 percent tax. Those whose employment includes stock option opportunities often have high salary years when options are exercised, and will now face the added 0.9 percent Medicare tax.
For those contemplating a large capital gain sale in the next months, closing that transaction within 2012 will ensure that these taxes are not in play. Often, large capital gain recognition is postponed until January of the next tax year in order to defer payment of the tax. But with these taxes starting in 2013, taxpayers will want to consider closing major transactions within 2012.
“Taxpayers will not only avoid the new 3.8 percent tax,” says Nick Houle, “they will also avoid the threat of increased regular income tax rates that are in the president’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 business), and also affect rental income, bonuses, and other passive investment income. Consult your tax advisor to help you interpret the application of these taxes to your situation, and discuss possible strategies to minimize the cost.
Chris Hesse, Tax Partner
firstname.lastname@example.org or 612-397-3071
Nick Houle, Partner
email@example.com or 612-376-4760