As previously discussed within the June 28, 2012 Tax Flash, the Medicare Contribution Tax will be in effect as of January 2013. The tax applies to individuals, estates and trusts and imposes an additional 3.8% tax on net investment income for taxpayers with modified adjusted gross income (MAGI) above threshold amounts.
For purposes of the new tax, MAGI is defined as the taxpayer’s adjusted gross income (or, AGI-which is basically total gross income for most taxpayers) plus any net foreign earned income which might be excluded from AGI under specific Internal Revenue Code provisions. Net investment income is generally investment income, such as interest, dividends, annuities, royalties, rent and capital gains, reduced by the deductions applicable to such income, such as advisory fees.
Even though the tax won’t take effect until next year, there are a number of planning options available to help taxpayers reduce the effects of the tax. Since the tax applies to the lesser of a taxpayer’s net investment income or the excess of the taxpayer’s MAGI over the threshold amount, there are two basic strategies to plan for the tax increase:
those which lower the taxpayer’s net investment income and
those based on lowering MAGI.
Below are some examples of strategies that may reduce the effects of the surtax:
Strategies Based on Lowering Net Investment Income
Taxpayers may consider shifting investments to municipal bonds, which are tax-free for Federal purposes. Traditionally, the decision to invest in municipal bonds is driven by the difference in the return given by municipal bonds as compared to taxable investment vehicles such as corporate bonds. The applicability of the new tax to taxable corporate bonds, but not the nontaxable municipal bonds, might narrow this difference. Factoring in the potential for state non-taxability, the municipal bond may become an even more attractive investment if the Medicare Contribution Tax survives.
Investing in a life insurance policy gives a taxpayer tax-free growth until the earnings are withdrawn from the policy, thus, a taxpayer without urgent needs for immediate cash flow may consider investing in a life insurance policy as a tax-deferral strategy. For instance, a taxpayer can purchase a life insurance policy by paying a single premium of $50,000. Ten years later, when the policy’s cash value has increased to $80,000, the taxpayer decides to withdraw $5,000. Given these facts, none of the $30,000 of earnings to date is subject to tax since it remains in the policy, nor is the withdrawal of $5,000 subject to tax since it is a return of the initial investment. This result applies specifically to life insurance contracts where the first dollars distributed are a return of the investment. Until the entire $50,000 is withdrawn, there will be no tax due.
Should the taxpayer start to recover earnings from the policy, he may be subject to the surtax but only if the MAGI exceed the threshold amounts. Even though the earnings drawn from the policy will be subject to tax, the taxpayer still may be able to plan around the additional tax by deferring withdrawals of earnings until a tax year when his MAGI is below the threshold.
Rental Real Estate
An investment in rental real estate may enable taxpayers to have what would seem to be the best of both worlds: an opportunity to reduce net investment income while still retaining a positive cash flow from the investment. This is possible because of the deduction allowed for depreciation, which can reduce a taxpayer’s rental income position into a tax loss, and offset net investment income for purposes of the surtax. The rental loss may also reduce the taxpayer’s taxable income (depending on other sources of passive or rental income or the level of active participation in the rental properties.) Should the investment property have the potential to appreciate in value, this strategy may be a very effective investment tool.
Timing of Estate/Trust Distributions
The new tax applies to trusts, as well as, individual taxpayers. Since many trusts are created to generate interest and dividend income, they may be hit especially hard with this new provision. Taxpayers who are beneficiaries or trustees of trusts should consider shifting income from the trust to the individual in order to reduce the income of the taxpayer’s trust. Under the “65-day rule” set forth in the tax code, a fiduciary is allowed to treat distributions made within 65 days after the trust’s year end as if they were made during the year (for calendar-year trusts, as if they were made by December 31st). This provides a planning opportunity for both the trust and the individual.
Since the trust is allowed a deduction for income distributed to the beneficiary, it is important to determine the most tax-efficient amount to distribute. In addition to potential income tax savings resulting from the disparity between the trust income tax brackets (35% on income above $11,650 for 2012) and individual brackets (35% on income above $388,350 for single individuals in 2012), the threshold amounts for the surtax are significantly lower for trusts than they are for individuals. Thus, a trust that retains income may be subject to the surtax, whereas the same amount of income may be passed through to the individual beneficiary and still be below the threshold amount at the beneficiary level. For instance, by distributing $50,000 of trust income to a beneficiary with sufficiently low MAGI, a potential surtax savings of $1,900 is generated, in addition to any amount saved by allocating the income to the lower individual rates.
Strategies Based on Lowering MAGI
Roth IRA Conversion
A long-term strategy for reducing MAGI may consider converting a traditional IRA to a Roth IRA. This approach would certainly create significant tax in the initial year of conversion, however, the long-term benefits should be weighed against the high upfront cost. In terms of this strategy as it relates to the surtax, the initial conversion will increase a taxpayer’s MAGI (if done after December 31, 2012) but would not be included in net investment income. This strategy would be a possible consideration for the taxpayer whose MAGI is already above the threshold, since the additional income will not affect the determination of whether they are subject to the surtax and the total amount of net investment income will not increase.
The long-term use of this strategy means that the income grows tax free within the Roth IRA, and the amounts withdrawn in the future are tax exempt as well. This allows the taxpayer to receive income without increasing MAGI or subjecting the income to the surtax as net investment income, and avoids the mandatory distributions for individuals over 70 and certain heirs.
Charitable Remainder Trusts
If a taxpayer has a charitable intent, he may consider creating a charitable remainder trust as a way to reduce his MAGI over the term of the trust. A charitable remainder trust consists of two pieces: the income interest and the remainder interest. During the term of the trust, the income interest is usually paid to the donor or another named beneficiary. When the term of the trust ends, the remainder is paid to a designated charity.
Use of these trusts have several planning possibilities for the taxpayer. In addition to a charitable contribution deduction equal to the present value of the remainder interest in the year the trust is established, the taxpayer spreads the income recognized from the trust investment over the term of the trust. This has the effect of harboring net investment income in a tax-exempt environment while at the same time leveling income over a longer period of time, which may help the taxpayer keep his MAGI below the threshold amount.
In keeping with the idea of smoothing income over a number of years, taxpayers who are looking to sell appreciated assets may consider using an installment sale to reduce the amount of their MAGI. By selling an asset in exchange for a promissory note rather than cash, the taxpayer receives an income stream over a period of years. This would defer gain over the life of the note, allowing the taxpayer to keep his MAGI below the threshold amount. This strategy may be useful for those looking to sell appreciated assets and willing to accept a long-term cash stream as opposed to a higher upfront inflow. Remember that the interest received during the term of the installment note (which is required by law) is net investment income and is therefore subject to the additional tax.
We will be discussing these and other strategies with our Marcum clients over the upcoming months. In the mean time, we encourage you to contact your Marcum advisor if you would like to explore these options or discuss any aspect of the new surtax.