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Planning Strategies in Wake of the New 3.8% Medicare Surtax

The Supreme Court’s decision upholding the Affordable Care Act confirmed that taxpayers whose income exceeds a threshold amount will be subject to a 3.8% Medicare surtax on net investment income, effectively raising their marginal income tax rate. However, whether the Bush era tax cuts will be extended and, if so, for whom, remains an open question. In light of this uncertainty, CPAs may want to start planning for possible 2013 tax increases now, particularly for clients who will benefit from transferring assets to family members, decisions that can take time to make. Download a free Medicare surtax chart from Robert Keebler, CPA, and listen to his recent podcast on how to plan for the Medicare surtax below.

Understanding the 3.8% Medicare surtax under the healthcare law

Robert S. Keebler, CPA, MST, DEP, Partner, Keebler & Associates, LLP. Bob is a 2007 recipient of the prestigious Distinguished Estate Planners award from the National Association of Estate Planning counsels. From 2003 to 2006, Bob was named by CPA Magazine as one of the top 100 most influential practitioners in the United States. He is the past Editor-in-Chief of CCH's magazine, Journal of Retirement Planning and a member of CCH's Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration.  



This audio webcast was originally recorded June 29, 2012.


On behalf of the PFP Division of the AICPA, this is Bob Keebler, bringing you planning strategies in the wake of the Supreme Court's decision on health care.

Earlier today the Supreme Court ruled that the health care bill was constitutional.  This holding means that beginning January 1st, 2013, a Medicare payroll tax of 0.9% will be imposed on individuals with income exceeding $200,000 and married couples with income exceeding $250,000.  Also beginning in January is a 3.8% surtax which applies to the lesser of net investment income or the amount by which AGI exceeds $200,000 for individuals and $250,000 for married couples.  To reiterate, the surtax applies to applicable net investment income if the taxpayer's AGI is above the threshold.

The mandate or penalty is scheduled to take effect January 1st, 2014.  It will impose an additional tax on those who cannot secure insurance.  Beginning in 2014, the annual penalty will be $95 or 1% of income, whichever is greater.  This will eventually rise to $695 or 2.5% of income by 2016.  Families will have a maximum flat penalty of $2,085, but will still owe 2.5% of income if that is greater.

In 2012, all W-2s will include the value of health insurance provided to employees.  Effective in 2011, the penalty on non-qualified distributions from HSAs will be doubled to 20%.  For 2013, the itemized deduction floor on medical expenses will increase to 10% of AGI.  Beginning in 2018, the Cadillac tax will be implemented.  This will be a 40% excise tax on the portion of health care plans that exceed $10,200 for individuals or $27,500 for families.

Beginning in 2014, a refundable health tax credit will be available to help individuals with low income to purchase coverage.  Also beginning in 2014, a nondeductible fee of $2,000 per employee will be imposed on business which do not provide adequate coverage.  The first 50 employees are not counted under this threshold.

Also, recognizing there's a lot to learn, Speaker of the House John Boehner has promised to repeal what's left of Obamacare so that all these new rules we're learning will never be implemented.

Perhaps the most important part of the Court's decision is that the 3.8% Medicare surtax will stand.  This means beginning on January 1st, 2013, a new 3.8% Medicare surtax will apply to all taxpayers whose income exceeds a threshold amount.  This new surtax will, in essence, raise the marginal income tax rate for affected taxpayers.  For example, beginning in 2013, a person in the 39.6% bracket -- i.e., the highest marginal tax rate that could be in effect in 2013 -- would increase to 43.4%.  So what we're looking at basically across the board is an increase on investment income of 3.8%.

Now, there's a little bit of a calculation that goes into this.  The new Medicare surtax is equal to 3.8% times the lesser of the following: net investment income or the excess of modified adjusted gross income for such a taxable year over a threshold amount.  Now, let's talk about what those threshold amounts are.  Threshold amount is going to be $250,000 for married couples and $200,000 for individuals.  But for estates and trusts, the threshold amount will be right around $12,000.  So for estates and trusts, immediate steps are needed to plan for this.

So the new Medicare surtax is equal to 3.8% times the lesser of, in the context of an estate or trust, undistributed net investment income for such taxable year or the excess of adjusted gross income for such taxable year over the dollar amount of which the highest bracket begins.  So basically, once you hit $12,000 of income in a trust, give or take a little bit there, you're going to be subject to a 3.8% surtax.  So especially for trusts that are accumulating prince -- principal and income, and they're not making distributions, those trusts are going to be hit with the 3.8% surtax.

One very critical thing for most of us to pay attention to is the year-end we choose for individuals that died in 2011 or 2012.  By selecting the right year end we may be able to stretch out the rule so that the 3.8% surtax doesn't apply until December 1st, 2013.  You would do that by picking a November 30th, 2012, year end, and then the next year starts on January 1st, 2012, and this tax only applies to years that begin on or after January 1st, 2013.  So we can stretch that out a little bit.

Now, there's three critical terms we need to understand when we're working with the 3.8% Medicare surtax: net investment income, the threshold amount and modified adjusted gross income.  So those are the keys.  Now, net investment income is defined as interest, dividends, annuities, rents, royalties, income derived from a passive activity and net capital gains.  It doesn't include wages.  It doesn't include distributions from IRAs and qualified plans.  It doesn't include self-employment income or the gain on an active sale of a trade or business.  There'll be a lot more to learn, but this is a quick overview.

Now, I want to come back to these threshold amounts.  Basically, in 2013, the threshold amount for single taxpayers will be $200,000, married 250, estates and trusts $11,650.  The key is modified adjusted gross income.  Basically, the front page of the return is going to give us our modified adjusted gross income.  Modified adjusted gross income means adjusted gross income, basically line 37 plus that foreign earned income that's been excluded from income, and that's going to be our adjustment.

Okay, now, there's a number of examples.  I've provided to everyone a chart which is called Understanding the Health Care Surtax.  From the front, we go through the law, but on the back we have 23 separate examples to help you get your arms around how this works.  I would encourage all of you to study that chart.  It's a quick read.  Within an hour, I think you'll have a real good feel for how this is going to apply in your practice.  Let me give you a couple of quick examples, just so you can start to think like this.

John, a single taxpayer, has $100,000 of salary and $50,000 of net investment income for the year.  A 3.8% surtax would not apply, because his modified adjusted gross income is less than $200,000.  Now, Linda, a single taxpayer, has $225,000 of net investment income, no other sources of income.  The 3.8% surtax will only apply to $25,000, so $200,000 of threshold, $225,000 of net investment income minus the $200,000 threshold means that $25,000 will be exposed to the 3.8% tax.

Terry and Tina, married filing jointly, have $300,000 of salaries and absolutely no investment income.  The 3.8% surtax will not apply to them because they have no investment income.  Now, same case, except Peter and Paula have $400,000 of salaries and $50,000 of net investment income.  They're going to pay the 3.8% surtax on $50,000.  So basically, because they're over the threshold amount, they have to pay the 3.8% surtax on their investment income.

So this is going to affect a lot of taxpayers.  It's also going to affect many estates and trusts, okay?  So that's something we have to understand.  Now, the strategies planning around the surtax, municipal bonds, tax-deferred annuities for people that are still working, life insurance, rental real estate, where you have depreciation.  Life insurance is going to work because life insurance is tax-free when you die, obviously.  Very effective for bypass trusts.  Life insurance also works because I can borrow my principal and not have to pay tax.  Oil and gas investments will continue to work because of the large IDC deductions you receive up front and because you have depletion allowances along the way.  Basically, it's our tried and true tax shelters that are going to continue to work.

But we also want to focus on the choice of accounting years for estates and trusts, and very much we're going to be focused on the timing of estate and trust distributions and how that will play into the surtax.  So when you work through this, there is a lot to know.  And basically we're all -- every time a client asks you a question on a going-forward basis, you're going to have to measure that question not only from an income tax perspective, but looking at the AMT results, and then finally looking at what's going to happen under this new surtax.  So again, a lot to cover.  And let's jump back in, though, and let's look at some strategies.

Okay, so one of my biggest strategies is going to be life insurance.  Another big strategy will be what we call the leapfrog annuity.  Using annuities to shelter income -- say, for a surgeon that's 55 years old, he's still working, but he has a lot of conservative investments, he might use an annuity to leapfrog until he retires.  Transfer that income out over his wages so that all that ex-passive income subject to a surtax does not hit his tax return until he's fully retired and no longer has those wages.

When we're planning around to reduce modified adjusted gross income, not just investment income.  Our Roth conversions will continue to be very popular.  Charitable remainder trusts will -- there will be a renaissance in charitable remainder trusts as people sell positions and securities because they're not going to want to sell all in one year, or they might drop it into a charitable remainder trust and then take distributions out over a 15- or 20-year period of time.

I think non-grantor charitable remainder trusts will also have some efficacy, and installment sales will come back more than we've seen in the past, because instead of selling a building, an apartment building in one year and having a $2 million gain, I might spread that gain out over ten or 15 years through an installment note.

One of the things on the Roth IRA we have to consider is Roth IRAs will probably be looked at as a way around the surtax, because they will reduce modified adjusted gross income.  So they're going to put a dent in modified adjusted gross income.  I think there's a lot to cover here, but we really want to take a look at how Roth IRAs play into your wealthier clients that are going to have major-league surtax problems.

Okay, now again, charitable remainder trusts, why would we do that?  We would to the charitable remainder trusts because we will avoid recognizing the income of one year, but maybe spread it over a ten- or 15-year term for the whole entire charitable remainder trust.  When you run the math, typically it's hard to make a charitable remainder trust work without a charitable intention.  This may bring that much closer together as a decision.  When you're designing your charitable trusts, remember, you can do these annuity trusts or charitable remainder unit trusts.

So there's truly a lot to cover, okay?  There's truly a lot to cover.  I think we're just starting here, and I'm hoping that my chart will help all of you get your arms around this.  Talk to your clients about this.  You -- We are at a tremendous place in our history, where really in the next six months you can probably make more impact than you ever could in your career.

On behalf of the PFP Division of the AICPA, this has been Bob Keebler, and thank you for joining us.


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