by Philip Herzberg, CFP®, CTFA, AEP®
The 3.8 percent Medicare surtax, a pivotal provision of the 2010 Patient Protection and Affordable Care Act, underscores the current significance of tax-conscious investment management for fiduciaries and higher-income taxpayers. This 3.8 percent tax on net investment income, which took effect January 1, 2013, is assessed on items such as dividends, taxable interest, rent, royalties, capital gains, and taxable income derived from passive activities in a trade or business (see sidebar on page 33 for details).
The surtax applies to the lesser of net investment income and the excess of modified adjusted gross income (MAGI) over $250,000 for those married, filing jointly or $200,000 for individual filers. For trusts and estates, this 3.8 percent levy also applies to the lesser of undistributed net investment income and the excess of adjusted gross income over the compressed threshold for the highest income tax bracket ($11,950 in 2013).
As a financial planner, what proactive strategies can you employ to mitigate the impact of the 3.8 percent Medicare surtax liability? Evaluate the following income tax minimization techniques in tandem with the other elements of your clients’ overall plans to determine if they fulfill their immediate and future objectives.
Prudent Planning Opportunities
Affected clients can still use exclusions and above-the-line deductions, such as contributions to qualified retirement plans, traditional IRAs, and health savings accounts to lower MAGI and potentially reduce the Medicare surtax. Higher-income taxpayers may leverage legitimate activity-related deductions in sole proprietorships (reported on Schedule C) or rental property (reported on Schedule E) to possibly reduce MAGI.
Although taxable payments from Social Security, traditional IRAs, and qualified retirement plans are not subject to the additional 3.8 percent tax, retirement income can raise AGI in a fashion that subsequently exposes other investment income to the Medicare surtax. Hypothetically, required minimum distributions from a traditional IRA can create as much as a 43.4 percent effective tax on IRA distributions (39.6 percent income tax plus 3.8 percent surtax on investment income created by distribution).
Shifting some or all of traditional IRA or qualified retirement plan assets to Roth accounts over time could control the taxable income your clients recognize in any one year, possibly helping them avoid these new taxes. Even though conversion income will count toward MAGI, this strategy can be worthwhile for clients who anticipate that their income will rise above the MAGI thresholds later in retirement when they are taking Social Security and retirement plan withdrawals.
Roth IRA distributions are not included in net investment income and the surtax. Tax-exempt and tax-deferred vehicles, such as municipal bonds, life insurance, and nonqualified annuities, may be favorable ways to shield clients’ exposure to the Medicare surtax. You also should assess each of these tax planning techniques in the context of your clients’ estate and wealth transfer plans, ascertaining that any restructuring of an investment portfolio to emphasize tax-free income is accompanied in accordance with time horizon, risk tolerance, and after-tax return.
Ensure your affluent clients are aware that there is no provision to automatically withhold this new Medicare surtax. In conjunction with a qualified tax adviser, decide whether your clients should adjust withholding amounts or start making estimated tax payments to avoid underpayment penalties.
Because there also is a separate 0.9 percent Medicare payroll tax on earned income (including net self-employment income) above MAGI thresholds, you should make projections relating to these clients’ expected income payments and time those cash flows accordingly over the next several years. Factor this 0.9 percent additional Medicare tax when devising planning strategies, especially for pre-retirees, self-employed individuals, and employees with substantial company stock benefits. Collaborate with your clients’ employers and tax professionals when exercising stock options or accelerating income payments to lessen the impact of a high MAGI in subsequent years when investment income may be high.
Viable Wealth Transfer Options
Another suitable way for your clients to mitigate the Medicare surtax and remove the asset from their estate is to gift ordinary income or net income producing property by outright transfer of assets to family members in a lower marginal income tax bracket. Similarly, gifting to a 529 plan can defer taxable income.
In addition, family limited partnerships can be applied by parents to shelter a portion of their net investment income from the Medicare surtax, as well as to gift partnership interests to younger generations in lower tax brackets. A qualified charitable distribution (extended in 2013 for taxpayers age 70½ or older to donate up to $100,000 income tax-free directly to charity from their IRA) also is a viable tactic for clients to help keep their MAGI below threshold limits. Talk to your clients about gifting highly appreciated stock or property to charity, rather than selling these assets and incurring as high as a 23.8 percent long-term capital gains tax (20 percent plus 3.8 percent surtax).
For clients who have substantial wealth and specific large assets, you may employ conventional techniques, such as charitable remainder trusts (CRTs), charitable lead trusts (CLTs), and installment sales to defer income and save taxes. Transferring property to a CRT provides your donor client with an immediate charitable income tax deduction for the present value of the remainder interest that can offset net investment income. Via income recognition timing, family members can benefit by receiving a level income stream during the CRT term with distributions passing later to a preferred charity.
With interest rates continuing to linger at historic lows, you also should discuss CLTs and installment sale opportunities with your ultra high net worth clients. If your clients are thinking about selling a piece of raw land that will generate a prodigious gain, an installment sale can spread the gain over a period of time and avoid exceeding annual MAGI thresholds.
Trust Tax-Reducing Techniques
Educate clients who are trustees or beneficiaries of an estate or trust on strategies that will be effective in limiting the new 3.8 percent Medicare surtax.
Foremost, if trustees have the ability to make non-pro-rata allocations among beneficiaries, it may make sense for them to distribute more net investment income to beneficiaries who are under the MAGI threshold at which the surtax applies. To this end, you can advise trustees to pay out income to beneficiaries who are in low income tax brackets, to be taxed at their lower rates, rather than at the estate’s or trust’s rate (39.6 percent after the $11,950 threshold is reached).
Guide trustees to increase material participation in an activity so that business income becomes non-passive and not subject to the Medicare surtax. If the trustee does not materially participate, the surtax also may be limited by distributing income from the activity to beneficiaries who materially participate in the activity.
Prior to devising distributions to mitigate income taxes, check with your fiduciaries for other implications, such as the possible disadvantages of exposing the allocated assets to a divorcing spouse or creditor. In addition to planning for the low federal tax threshold for income from trusts, account for state income taxes and rules that apply to your clients’ trusts.
When fiduciaries make in-kind trust distributions of an appreciated asset to beneficiaries, you can choose to have them recognize the gain at the trust level or have beneficiaries take a carryover basis in the asset with no gain to the trust. Remember that an election, if selected, would apply to all in-kind trust asset distributions made during the tax year. This election is not favorable if the trust beneficiary doesn’t plan to sell the asset anytime soon, because recognition of any gain would be deferred until the sale. As with the capital gains tax, the new Medicare surtax does not apply to assets held at death. (For more on avoiding post-ATRA trust tax rates, see Randy Gardner’s column)
Efficient coordination with estate and tax specialists is essential to facilitate a continuous strategic plan. Many investors created trusts with complex provisions designed to protect against a less preferable tax code. Initiate meetings as a team to present timely wealth planning solutions to your clients in the top tax bracket.
Philip Herzberg, CFP®, CTFA, AEP®, is president of FPA of Miami, director of public relations and awareness for FPA of Florida, and a member of the Estate Planning Council of Greater Miami Board of Directors.