Tax Strategy for the Week (June 21st, 2013)

Investments That Help Reduce Medicare Tax on Unearned Income

Tax Issue

Effective for taxable years beginning after December 31st, 2012, high-income individuals, estates, and trusts are subject to an unearned income Medicare contributions tax. The tax applies when the individual, estate, or trust has earning from certain investments, and total earnings exceed a threshold amount. The tax does not apply if the taxpayer’s income is below the threshold amount.

Applicable Tax Law

  • In the case of an individual, the tax is 3.8% of the lesser of net investment income, or the excess of modified adjusted gross income over the threshold amount.
  • The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.
  • Modified adjusted gross income is adjusted gross income increased by the amount excluded from income as foreign earned income or foreign housing exclusion under IRC Section 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income).
  • In the case of an estate or trust, the tax is 3.8% of the lesser of undistributed net investment income or the excess of adjusted gross income [as defined in IRC §67(e)] over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins (for 2012, $11,650). Exceptions: The tax does not apply to a nonresident alien or to a trust in which all unexpired interest is devoted to charitable purposes. The tax also does not appply to a trust that is exempt from tax under IRC Section 501 or a charitable remainder trust exempt from tax under IRC Section 664.
  • The tax is subject to the individual estimated tax provisions.
  • The tax is not deductible in computing any tax imposed by subtitle A of the Internal Revenue Code (relating to income taxes).
  •  Net investment income is investment income reduced by the deductions properly allocable to the income. Investment income is the sum of:

– Gross income from interest, dividends, annuities, royalties, and rents unless such income is derived in the ordinary course of a trade or business that is not subject to the tax,

– Other gross income derived from a business that is subject to the tax, and

– Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, other than property held in a trade or business that is not subject to the tax.

  • Investment income does not included items that are excluded from gross income under the income tax rules, such as interest on tax-exempt bonds, veteran’s benefits, and excluded gain from the sale of a principal residence.
  • In the case of a trade or business, the tax applies if the trade of business is a passive activity with respect to the taxpayer, or the trade or business consists of trading financial instruments or commodities [as defined in IRC §475(e)(2)].
  •  In the case of the disposition of a partnership interest or stock in an S corporation, gain or loss is taken into account only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. Thus, only net gain or loss attributable to property held by the entity which is not properly attributable to an active trade or business is taken into account.
  • A business of trading financial instruments or commodities is not treated as an active trade or business for purposed of this tax. Thus, income from the business of trading financial instruments or commodities is subject to the Medicare tax on unearned income.
  •  Investment income does not include distributions from a qualified retirement plan.
  • Investment income does not include amounts subject to self-employment tax.

Tax Planning Strategies

If an individual, estate, or trust has income above the threshold amount, the taxpayer should consider investing in investments that are not subject to the 3.8% unearned income Medicare contributions tax. The following planning strategies make use of investments that are not subject to the 3.8% tax.

Tax-exempt investments. Tax exempt-investments, such as interested earned on municipal bonds, are not subject to federal income tax. They are also not subject to the 3.8% Medicare tax. Thus, higher-income taxpayers with substantial interest income from bank CDs, or dividend and capital gain income from mutual funds, might want to take a second look at the tax-free income from municipal bonds. Even if the interest rate on the municipal bond is less than what the taxpayer is currently earning on his or her taxable investment, the after-tax net gain on the taxable investment may be less than the tax-free gain on the municipal bond.

Savings bonds. Even though interest income on U.S. savings bonds is subject to the 3.8% Medicare tax, tax on the interest can be deferred until they are cashed in. If they taxpayer waits until retirement to cash in the bonds, income may fall below the threshold amounts, thus avoiding the 3.8% Medicare tax on U.S. savings bond interest as well.

Qualified retirement plans. High-income taxpayers should max out their elective deferrals to their qualified retirement plans, such as 401(k) and 403(b) plans that allow employees to elect to defer tax on a portion of their wages that are contributed to the plan. The 3.8% Medicare tax does not apply to the earnings inside the plan, nor does it apply on distributions from the plan.

Nonqualified annuities. Even though the taxable portion of a distribution from a nonqualified annuity is subject to the 3.8% Medicare tax, earnings are deferred until distributions begin. If the taxpayer waits until retirement to take distributions from the annuity, income may fall below the threshold amounts, thus avoiding the 3.8% Medicare tax on annuity distributions as well.

Although nonqualified annuities are not insured by the FDIC, they are backed by the assets of the insurance company. Various state laws regulate insurance companies that offer annuity contracts that guarantee principal and require them to maintain certain funding levels to help prevent the insurance company from defaulting on the investment. Mutual funds, in contrast, do not guarantee the principal value of a particular fund. Nonqualified annuities that guarantee principal are considered by some experts as a safe alternative to bank CDs and U.S. savings bonds.

There is no annual limit on the amount of principal that can be invested. The investor has the option to switch money invested in bank CDs or other investments to nonqualified annuities all in one year. Thus, for anyone who currently is earning taxable interest income from a bank CD or other investment that is causing the individual’s net investment income to be subject to the unearned Medicare tax, switching to nonqualified annuities that guarantee principal will offer similar interest rates and similar investment security while reducing overall taxes..

Real estate, gold, and other investments that product capital gains. Even though capital gains are subject to the 3.8% Medicare tax, the tax does not apply until the capital gain is realized.

Some investors consider bank CDs and nonqualified annuities as not providing an acceptable rate of return on their investments. Some mutual funds and stocks have historically out-performed these so-called safe investments. By switching investments from mutual funds and stocks that produce dividend income to investments that product capital gains, the 3.8% Medicare tax will only apply in years where realized gains exceed realized losses.

If the taxpayer plans to recognize losses in the same year gains are recognized, the 3.8% Medicare tax may be minimized. If the taxpayer plans to recognize gains in years income falls below the threshold amounts, the 3.8% Medicare tax is avoided.

Possible Risks

  • Nonqualified annuities that guarantee principal are only as safe as the insurance company that issues the annuity contract. Thus, the risk factor is still greater than bank CDs and U.S. savings bonds which are backed by the U.S. federal government.
  • There are not guarantees when investing in high-risk investments, such as mutual funds, stocks, real estate, gold, and other investments that produce capital gains. A tax savings strategy designed to reduce the Medicare tax on unearned income can easily be wiped out if the taxpayer is forced to sell the investment at a loss.