Mitigating the new Medicare surtax | Kira Bravo

by Kira Bravo
Tax Manager, Moss Adams LLP

While some elements of the Patient Protection and Affordable Care Act have already taken effect, many of the biggest changes are still to come, including a 3.8 percent Medicare surtax that will hit certain taxpayers on Jan. 1, 2013.

Who is affected?

The surtax will apply to individuals and certain trusts and estates. For individuals, the surtax is imposed on the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds one of the following thresholds:

-$200,000 for single filers

-$250,000 for a married couple filing jointly

-$125,000 for a married couple filing separately

For trusts and estates, the surtax is imposed on the lesser of undistributed net investment income for the year or the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins.

As part of the act, net investment income includes interest and dividends, rents and royalties, annuities, passive activity income and (with certain exceptions) capital gains. As a quick reminder, the long-term capital gains rate increases from 15 to 20 percent on January 1, making the combined rate 23.8 percent.

Planning opportunities

To reduce or possibly eliminate your exposure to the new surtax, consider the following strategies:

-Reduce your MAGI by maximizing qualified retirement plan contributions and gifting income-producing property to charitable organizations.

-Maximize contributions to Roth IRAs, which are not included in MAGI or net investment income. While high-income taxpayers are typically precluded from contributing to Roth IRAs, account conversions from traditional IRAs to Roth IRAs are possible.

-Take advantage of gains harvesting. While complicated, this entails selling appreciated investments in 2012 to pay tax at today’s low 15 percent capital gains rate, and then repurchasing similar assets. Discuss with your tax advisor.

-Taxpayers making sales on an installment basis, in which taxes are paid over time as payments are received, may want to consider electing out of installment sale treatment to take advantage of today’s historically low capital gains rate. If you’re carrying an installment obligation, consider feasible alternatives to trigger the gain on those contracts to effectively lock in the 15 percent rate and avoid the 3.8 percent surtax.

-If selling your home, consider doing so before the end of 2012. The sale of a personal residence may be subject to the surtax if the gain is greater than the home sale exclusion ($250,000 for single taxpayers and $500,000 for a married couple filing jointly).

-Consider rebalancing investment portfolios to include municipal bond investments. Income from tax-exempt municipal bonds is not subject to the 3.8 percent surtax. You might also consider reducing investments in assets that generate income, such as interest and dividends.

-Pay special attention to how passive activities are classified. Elections may be made to group several activities together as nonpassive; however, classifying income as passive may be beneficial to taxpayers with sufficient passive losses to offset passive income.

-Consider setting up a charitable remainder trust (CRT) if you’re interested in making a large gift to charity. A CRT is a trust that consists of both an income interest and a remainder interest. A donor puts an asset into the trust and receives a predetermined stream of income over the trust term. At the end of the term, the remainder interest passes to the charity. The income stream can be structured to help keep the donor’s MAGI below the surtax threshold. Additionally, the donor is allowed an immediate charitable deduction for the present value of the remainder interest, and CRTs are tax-exempt entities that can sell assets tax free and reinvest the proceeds in another asset.

-Be sure to consult a professional before implementing a strategy to ensure it fits with your overall financial goals.

Kira Bravo has practiced public accounting since 2006. She provides tax planning, compliance and consulting services to closely-held businesses and their owners. She can be reached at 360-685-2223 or at

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