Planning for Potentially Higher Taxes on Investment Income


Through the end of this year, the so-called Bush tax cuts are locked in place. However, unless Congress takes action and the president approves (whoever he happens to be at the time), individual federal income tax rates will increase in 2013. Here is what is scheduled to happen to high-income individuals.

  • For 2013 and beyond, the top two rates on ordinary income, including net short-term capital gains, will increase to 36% and 39.6% (up from 33% and 35%, respectively).
  • For 2013 and beyond, high-income individuals may also be hit with an additional 0.9% Medicare tax on part of their wages and self-employment income. However, the additional 0.9% tax was part of the controversial 2010 Healthcare legislation, so it could be repealed or thrown out by the Supreme Court.
  • For 2013 and beyond, the maximum rate on most long-term capital gains will increase to 20% (up from 15%). However, an 18% maximum rate will apply to most long-term gains from selling assets that are: (1) acquired after 12/31/2000 and (2) held for more than five years.
  • For 2013 and beyond, dividends will be taxed at ordinary income rates, which could be as high as 39.6% (up from 15%).
  • For 2013 and beyond, high-income individuals may also be hit with an additional 3.8% Medicare contribution tax on all or part of their net investment income, which is defined to include long-term gains and dividends. However, the additional 3.8% tax was part of the controversial 2010 Healthcare legislation, so it could be repealed or thrown out by the Supreme Court.
  • For 2013 and beyond, the phase-out rules for personal and dependent exemption deductions and itemized deductions are scheduled to return with full force. These disguised tax increases will raise effective tax rates on investment income of higher-income individuals just that much higher.

Observation: It’s certainly possible that none of the aforementioned tax increases will actually come to pass. However the prudent thing to do is plan for the worst while hoping for the best. Planning for the worst is what we will do in this blog.

Details on Additional 3.8% Medicare Contribution Tax on Investment Income

For 2012, a 2.9% Medicare tax applies to salary and self-employment (SE) income. For an employee, 1.45% is withheld from his or her paychecks, and the other 1.45% is paid by the employer. A self-employed person pays the whole 2.9%. Investment income is not subject to the existing 2.9% Medicare tax.

Now for the bad news: starting in 2013 (which will be here before we know it), all or part of a high-income individual’s net investment income will get socked with an additional 3.8% “Medicare contribution tax” unless our Washington politicians take action.

Net Investment Income Defined. Net investment income for purposes of the additional 3.8% Medicare contribution tax is the sum of :

(1.) Net gain from property held for investment.

(2.) Gross income from dividends.

(3.) Gross income from interest.

(4.) Gross income from royalties.

(5.) Gross income from annuities.

(6.) Gross income from rents.

(7.) Gross income from passive business activities.

(8.) Gross income from the business of trading in financial instruments or commodities.

Minus deductions that are properly allocable to these income categories.

Exception for Business Activities: Income from categories 1-6 is generally not taken into account for purposes of the additional 3.8% Medicare contribution tax if the income is from a business activity.

Exception to the Exception: Income from categories 1-6 is taken into account if it is from a passive business activity or the business of trading in financial instruments or commodities. For example, net gains from selling passive rental properties could apparently be hit with the additional 3.8% Medicare contribution tax, and so could net gains from selling passive partnership interests and passive investments in S corporation stock.

Exception for Distributions from Tax-favored Retirement Plans: Net investment income for purposes of the additional 3.8% Medicare contribution tax does not include distributions from tax-favored retirement plans and accounts described in IRC Secs. 401(a) (qualified retirement plans), 403(a), 403(b), 408 (traditional IRAs), 408A (Roth IRAs), and 457(b).

Income Threshold and Tax Base. The additional 3.8% Medicare contribution tax will not apply unless Modified Adjusted Gross Income (MAGI) exceeds: (1) $200,000 for an unmarried individual, (2) $250,000 for a married joint-filing couple, or (3) $125,000 for those who use married filing separate status. These MAGI thresholds are not adjusted for inflation. MAGI means regular AGI plus the excess of the amount excluded from gross income under the IRC Sec. 911(a)(1) foreign earned income exclusion over any deductions or exclusions that are disallowed under IRC Sec. 911(b)(6) with respect to such excluded foreign earned income.

The additional 3.8% Medicare contribution tax will only apply to the lesser of: (1) net investment income or (2) the amount of MAGI in excess of the applicable threshold.

Example 1: Barry and Sherry, a married joint-filing couple, have 2013 MAGI of $265,000 and $60,000 of net investment income. They will owe the 3.8% additional Medicare contribution tax on $15,000 ($265,000 MAGI less the $250,000 threshold). The $570 ($15,000 x 3.8%) Medicare contribution tax should be included in their 2013 estimated tax payments.

Example 2: Harry and Teri, a married joint-filing couple, have 2013 MAGI of $350,000 and $60,000 of net investment income. They will owe the 3.8% Medicare contribution tax on $60,000 (the entire amount of their net investment income). This $2,280 ($60,000 x 3.8%) tax should be included in their 2013 estimated tax payments.

Example 3: Fritz, an unmarried individual, has 2013 MAGI of $180,000 and $100,000 of net investment income. He will not owe the 3.8% Medicare because his MAGI is below the $200,000 threshold for unmarried taxpayers.

Trust Income Can Also Be Affected. For a trust, the additional 3.8% Medicare contribution tax will apply to the lesser of: (1) undistributed net investment income or (2) the amount of AGI in excess of the threshold for the top trust federal income tax bracket. (For 2012, that threshold is a mere $11,650.)

Tax Rate Impact. Thanks to the additional 3.8% Medicare contribution tax in conjunction with other scheduled rate increases, the following maximum federal rates will apply in 2013 unless something changes:

  • 23.8% (20% + 3.8%) on net long-term gains in excess of net short-term capital losses (versus 15% for 2012).
  • 23.8% (20% + 3.8%) on net Section 1231 gains from passive business activities (versus 15% for 2012).
  • 43.4% (39.6% + 3.8%) on net short-term gains in excess of net long-term capital losses (versus 35% for 2012).
  • 43.4% (39.6% + 3.8%) on net dividend income (versus 15% for 2012).
  • 43.4% (39.6% + 3.8%) on net interest, royalty, annuity, and rental income (versus 35% for 2012).
  • 43.4% (39.6% + 3.8%) on net ordinary income from passive business activities and net ordinary income from the business of trading in financial instruments or commodities (versus 35% for 2012).

Planning to Mitigate Higher Taxes on Investment Income

Investment gains that would be subject to higher tax rates if they are recognized in 2013 won’t be hit with those higher rates if the gains are recognized this year. Therefore, investors should consider triggering gains by unloading affected appreciated assets by 12/31/12 instead of hanging onto them. That said, the tax tail should not wag the investment dog. Investors should only unload assets that they are thinking about unloading anyway. After the recent stock market run-up, it should not be too hard to find some.

On the other hand, holding onto depreciated investment assets (say rental real estate properties that were acquired at the top of the market) until after this year could be beneficial because losses from unloading them in 2013 and beyond could shelter investors from higher future tax rates on net investment income. Losses would reduce: (1) taxable income for regular tax rate purposes, (2) AGI for purposes of various phase-out rules, and (3) MAGI and net investment income for purposes of the additional 3.8% Medicare contribution tax.

Don’t Forget about the Other New Medicare Tax Scheduled to Take Effect Next Year

We have more bad news, although this item doesn’t affect investment income. Starting with tax years beginning in 2013, an extra 0.9% Medicare tax will be charged on: (1) salary and/or SE income above $200,000 for an unmarried individual, (2) combined salary and/or SE income above $250,000 for a married joint-filing couple, and (3) salary and/or SE income above $125,000 for those who use married filing separate status. These thresholds are not adjusted for inflation.

For self-employed individuals, the additional 0.9% Medicare tax hit will come in the form of a higher SE bill. However, the additional 0.9% Medicare tax will not qualify for the above-the-line deduction for 50% of SE tax. The additional 0.9% Medicare tax must be taken into account for estimated tax payment purposes.

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About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

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