While the finding landing point of individual marginal tax rates in 2013 is uncertain, the new 3.8% Medicare surtax that is part of the "Affordable Care Act" (ACA), aka Obamacare, is not. If you are a high-income taxpayer you could be subject to this new surtax.
Here's the whole story:Beginning in 2013, the new 3.8% Medicare surtax applies to the lesser of "net investment income" (NII) or the excess of modified adjusted gross income (MAGI) over the applicable threshold. The MAGI threshold is $200,000 for single filers and $250,000 for joint fliers. With some astute moves between now and year-end, one may be able to reduce the hit from the new surtax or even avoid it completely.
Here are 8 ways to defuse the surtax:
1. Don't be passive about investments. NII includes amounts generated by passive activities such as rental real estate and business operations conducted through pass-through entities such as LLCs and S corporations in which you do not take an active roll. Become active by "materially participating" in the business activity or reduce your income exposure, if feasible.
2. Add munis to your portfolio. The income from municipal bonds, or certain municipal bond funds, is completely exempt from federal income tax and the new Medicare surtax. Therefore, buying more munis will not result in the extra tax on net investment income.
3. Cash in on appreciated property. If it makes good financial sense, one may want to arrange to sell stocks, rental real estate, or other appreciated assets before year-end. Always look at the economic aspect of a transaction before the tax attributes.
4. Bulk up your 401(k) account. Distributions from qualified retirement plans and IRA's do not count as net investment income. Therefore, the more you put into a qualified plan, the more income you can shelter form the Medicare tax. Plus, the funds are growing on a tax-deferred basis, or a tax-free basis with a Roth IRA.
5. Move up a home sale. Assuming you were planning to sell your personal residence soon anyway, complete the sale before 2013. Although joint filers can exclude from federal income tax the first $500,000 of gain from selling a principal residence ($250,000 for single filers), the Medicare tax can potentially hit any portion of the gain over this exclusion.
6. Arrange an installment sale. If you're selling rental real estate, an installment sale may be the only way to get a buyer to agree to the deal. For sales in which you received payments over two or more years, the proportionate gain is taxable in the years the payments are received. By staggering payments based on your projected tax brackets, you may reduce the impact of both regular income taxes and the surtax. Alternatively, if it's better taxwise overall, one can elect to pay the entire tax due on a 2012 sale with your 2012 return.
7. Switch to a Roth IRA. Although traditional IRA distributions are not treated as NII, they can still increase your MAGI in a year in which the Medicare surtax applies. Please note that if you plan on converting a Traditional IRA to a Roth IRA, it may be more advantageous from a tax standpoint to complete the conversion in 2012.
8. Set up a charitable remainder trust (CRT). This wealth transfer strategy was valuable prior to the imposition of the Medicare surtax. Now it is even more attractive. Typically, you receive a charitable deduction for transferring property to the CRT, which pays out income over time. Then the predesignated charity receives the remainder. This technique may enable one to keep their income below the surtax threshold for the trust's term.
Well, that is it. Please remember to consult your financial and/or tax advisor before you make any financial decisions.
I have one area of tax planning left to consider: What can a small business do before the end of the year to reduce their tax liability? Keep your eyes peeled for this info.
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