Planning to Minimize the New Medicare Taxes
Copyright: | (c) 2011 New York State Society of Certified Public Accountants |
Source: | Proquest LLC |
Wordcount: | 3892 |
The
The
In response to the concerns about rising
Additional Hospital Insurance Tax on Higher Incomes
Prior to the enactment of the 2010 Health Care Act, the
For tax years beginning after
To illustrate, consider a single taxpayer who has wages of
Employers will be required to withhold the additional 0.9% HI tax on wages but will not be required to match the additional tax. As a result, self-employed taxpayers will be subject to the additional tax of 0.9% on excess self-employment income, not 1.8%. (For self-employed taxpayers, neither the 0.9% HI tax on excess self-employment income, nor the 3.8% HI tax on net investment income is eligible for the 50% deduction in calculating adjusted gross income, as the other self-employment taxes are.)
The new HI tax imposes a "marriage penalty" on certain taxpayers. Unlike the 1.45% HI tax, which is levied separately on each spouse's wages, the additional 0.9% tax is assessed on a couple's combined wages in excess of
The new HI tax also creates as an additional compliance burden for married taxpayers. Because employers are required to withhold the additional tax only on wages in excess of
Taxpayers should be aware that the HI tax threshold amounts will not be indexed for inflation, unlike the taxable income brackets for the federal income tax. As a result, over time more taxpayers and more income may be subject to the additional 0.9% HI tax as wages increase.
Additional HI Tax on Net Investment Income
Since the inception of
The 3.8% tax is levied on the lesser of net investment income or modified adjusted gross income (AGI) in excess of a certain threshold (IRC section 1411 [a] [I]). The thresholds are the same dollar amounts that apply to the 0.9% HI tax on high-income taxpayers:
To illustrate, consider a single taxpayer with
It is possible for a taxpayer to be subject to both the 3.8% HI tax on net investment income and the additional 0.9% tax on wages and self-employment income in excess of the threshold.
To illustrate, assume a single taxpayer has wages of
The investment income that is subject to the new tax includes interest, dividends, rents, royalties, annuities, and capital gains but is reduced by expenses that are allocated to the income (IRC section 141 l[c]). Income from the business of trading in financial instruments or commodities is also treated as investment income (IRC section 1411[c][2][B]). Investment income also includes income from a trade or business in which the taxpayer invests but does not materially participate. Income from this type of business is treated as passive activity income (IRC section 469). To materially participate, a taxpayer must be involved in the operations of the business on a regular, continuous, and substantial basis (IRC section 469[h]). Although income from a business in which a taxpayer materially participates is not treated as investment income, it is treated as selfemployment income, which is subject to the 2.9% HI tax and possibly the 0.9% HI tax on higher wages and self-employment income.
To illustrate, assume a single taxpayer earns
Net investment income does not include distributions from qualified retirement plans (IRC section 1411[c][5]). These plans include qualified pension, profit-sharing, and stock bonus plans (IRC section 401 [a]), qualified annuity plans (IRC sections 403 [a] and [b]), individual retirement accounts (IRA) and Roth IRAs (IRC sections 408 and 408[A]), and deferred compensation plans of state and local governments and tax-exempt organizations (IRC section 457 [b]). Note, however, that all of these distributions, except the Roth IRA distributions, are included in the calculation of modified AGI and, as a result, may cause net investment income to be subject to the 3.8% HI tax.
As noted earlier, the HI tax on net investment income is assessed on the lesser of the net investment income or modified AGI in excess of the threshold. Modified AGI is a taxpayer's adjusted gross income increased by any foreign earned income exclusion in excess of any foreign housing expense deduction (IRC section 141 l[d]). For the typical taxpayer, modified AGI is simply gross income minus the deductions from AGI for items such as alimony paid and penalties on early withdrawals of savings (IRC section 62 [a]).
Anomalies in the New Taxes
As explained above, the high-income HI tax is imposed on wages and self-employment income in excess of a certain threshold. Wages that are deferred through a salary reduction agreement with a tax-exempt organization or public school (under an IRC section 403 [b] plan) and wages that are deferred by a state or local government (under an IRC section 457 plan) are treated as wages for purposes of the new 0.9% HI tax (IRC section 3121[a][5][D]). Therefore, although the deferred income is not reported as gross income for federal income tax purposes because the taxpayer will not have access to this income until retirement or reaching age 59Vi, the income can cause the taxpayer to be subject to the 0.9% tax. The deferred income, will not, however, have an effect on the calculation of the 3.8% HI tax on net investment income because it is not part of gross income and, therefore, not part of the modified AGI used to calculate the 3.8% tax.
To illustrate, assume that a single taxpayer earns a salary of
Steps to Minimize the Tax Bite
There are several actions taxpayers can take to help minimize the effect of the new HI taxes. Taxpayers who have individual retirement accounts (IRA) as well as eligible employer retirement plans such as IRC section 401(a) qualified plans, section 403(a) qualified annuities, section 403(b) taxdeferred annuities, and section 457 plans should consider converting those accounts to Roth IRAs prior to 2013. Distributions from traditional IRAs and eligible employer retirement plans are taxed as gross income, whereas distributions from Roth accounts are tax free. Prior to 2010, modified AGI limitations prevented high-income taxpayers from using the rollover provisions (IRC section 408A[c][c][B]). Beginning on
Taxpayers who plan on selling capital assets such as land or art should consider using the installment provisions to recognize any capital gain on the sale (IRC section 453). Because capital gains are part of modified AGI and are considered investment income, a large capital gain recognized in one year can result in that income being subject to the 3.8% net investment HI tax. Under the installment method, recognition of the gain is spread over the years that payments on the sales contract are received. The amount of gain included in income each year is equal to the amount of payment received that year multiplied by the ratio of the gross profit on the sale to the contract price.
For example, assume that a taxpayer sells land for
To illustrate, assume that on
Taxpayers should be warned that not only are sales of individual securities subject to the wash sale mies, but also sales of mutual fund shares (
As noted earlier, taxpayers who have IRC section 403(a) or 403(b) employee annuities should consider converting those annuities to Roth accounts prior to 2013, because distributions from Roth IRAs are not considered part of modified AGI. The drawback to making the conversion is that a taxpayer must pay income taxes on the conversion amount in the year of the conversion. If the taxpayer does not want to pay the income tax at this earlier date, another way to limit the impact of annuity distributions on modified AGI and, therefore, the 3.8% HI tax, is to arrange for the annuities to be paid out over a longer period of time. Taxpayers must be sure, however, that the required minimum distribution rules under IRC section 401(a)(9)(A)(i) are met for each year; otherwise, they could face a 50% penalty on the amount of the inadequate distribution.
Plan Ahead
Taxpayers and their advisors should start reviewing their financial situations now in order to help minimize the higher HI taxes that take effect
High-income taxpayers who will retire in the next few years and be covered by Medicare Part B (the program that provides for doctors' services and outpatient care) should be aware that, since 2007, Medicare Part B premiums have been based on a taxpayer' s modified AGI. Prior to 2007, all Medicare Part B recipients paid about 25% of the cost of Part B coverage, with the balance paid by the federal government. Since 2007, high-income recipients have had to pay premiums ranging from 35% to 80% of the total projected per capita Part B expenditures. High-income
The Exhibit shows the Part B premium schedule for 2011. The premiums are adjusted by the
It is interesting to note that, in determining the Part B premiums, the modified AGI for couples who file jointly is double that for single taxpayers. As discussed earlier, the modified AGI used to determine the new HI taxes of 0.09% and 3.8% for married taxpayers is only
The change in the calculation of Part B premiums will require high-income taxpayers who intend to retire in the near future to be particularly careful in how they plan their transactions in order to minimize the new HI taxes. For example, if a taxpayer takes steps in 2012 to shift income to that year to help reduce exposure to HI taxes in 2013, the result could be higher Part B premiums if the taxpayer retires in 2014 - these higher costs result from the 2014 premiums being based on 2012 modified AGI.
Taxpayers should be aware that the HI tax threshold amounts will not be indexed for inflation, unlike the taxable income brackets for the federal income tax.
Distributions from Roth IRAs in later years will not be treated as gross income and will not affect a taxpayers modified AGI for purposes of the 3.8% net investment HI tax.
Future sales of stocks, bonds, and properly should be structured carefully to minimize the amount of investment income reported each year after 2012.
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