Anderson ZurMuehlen Blog

Planning Around the New Medicare Tax on Investment Income

The new 3.8 percent Medicare tax on net investment income took effect at the beginning of this year. It only affects higher-income individuals, but that can include anyone who happens to have big one-time taxable income or gains in one year. This article covers some planning strategies that individuals can implement between now and year end to avoid or minimize the new tax for 2013.

Net Investment Income Tax Basics

The following types of income and gain (net of related deductions) are generally included in the definition of net investment income and thus potentially exposed to the 3.8 percent tax.

  • Gains from selling assets held for investment including gains from selling investment real estate and the taxable portion of gains from selling personal residences.
  • Capital gain distributions from mutual funds.
  • Gross income from dividends and interest (not including tax-free interest such as municipal bond interest).
  • Gross income from annuities and royalties.
  • Gross income and gains from passive business activities (in which you do not materially participate) and gross income from rents. Gross income from non-passive business activities is excluded from the definition of net investment income and so is gain from selling property held in such activities.
  • Gains from selling passive partnership interests and S corporation stock (meaning you do not materially participate in the partnership or S corp’s business activities).
  • Gross income and gains from the business of trading in financial instruments or commodities (whether you materially participate or not).

Affected Individuals

You are only exposed to the 3.8 percent Medicare tax if your modified adjusted gross income (MAGI) exceeds: $200,000 if you’re unmarried, $250,000 if you’re a married joint-filer or qualifying widow or widower, or $125,000 if you use married filing separate status.

The amount subject to the 3.8 percent tax is the lesser of:

  1. Your net investment income or
  2. The amount by which your MAGI exceeds the applicable threshold.

For this purpose, MAGI is defined as regular AGI from the bottom of page 1 of your Form 1040 plus certain excluded foreign-source income net of certain deductions and exclusions (relatively few individuals are affected by this add-back).

Note: The 3.8 percent tax can also hit estates and trusts that have investment income but we will not cover them in this article.

Planning Strategies Must Aim at Proper Target

Since the 3.8 percent Medicare tax hits the lesser of: your net investment income or the amount by which your MAGI exceeds the applicable threshold, planning strategies must be aimed at the right target.

  • If your exposure to the tax mainly depends on your net investment income, focus first on strategies that will minimize that amount.
  • If your exposure to the tax mainly depends on your MAGI, concentrate on strategies that will reduce that number.

Here are three examples to illustrate different taxpayers’ situations.

Example 1: Target Net Investment Income

In 2013, you will file as an unmarried individual. Unless something changes, you will have $370,000 of MAGI, which includes $95,000 of net investment income. You will owe the 3.8 percent Medicare tax on all net investment income (the lesser of your excess MAGI of $170,000 or your net investment income of $95,000).

Your exposure to the 3.8 percent tax mainly depends on your net investment income level. Therefore, you should focus first on strategies to reduce that amount. For instance, you could sell loser securities from your taxable brokerage firm investment accounts to offset earlier gains. Additional strategies are explained later in this article.

In contrast, strategies that would lower your MAGI would not reduce your exposure to the 3.8 percent tax unless they reduce your MAGI by a whole lot. For instance, making an additional $15,000 deductible contribution to your tax-favored retirement account would not by itself reduce your exposure to the 3.8 percent tax.

Example 2: Target MAGI

In 2013, you and your spouse will file jointly. You plan to have $325,000 of MAGI, which includes $100,000 of net investment income. You will owe the 3.8 percent Medicare tax on $75,000 (the lesser of your excess MAGI of $75,000 or your net investment income of $100,000).

Your exposure to the tax mainly depends on your MAGI level. Therefore, you should focus there first. For instance, making $25,000 of additional deductible contributions to your tax-favored retirement accounts would reduce your MAGI by $25,000 and therefore reduce the 3.8 percent tax. Selling loser securities from your taxable brokerage firm accounts to offset earlier gains would also reduce your MAGI.

In contrast, using a method that allocates more deductions to offset your investment income would not reduce your bill for the 3.8 percent tax unless the method reduces your net investment income amount by a great deal, which is not likely.

Example 3: Reduce the Impact of One Big Transaction

In 2013, you and your spouse will file jointly. Between now and year end, you expect to sell a greatly appreciated vacation home, which you’ve owned for many years. The whopping $650,000 gain will be fully taxable for federal income tax purposes and will also count as investment income for purposes of the 3.8 percent tax. Let’s assume you’ll have no other investment income and no capital losses. But you’ll have $150,000 of MAGI from other sources (salary, bonuses, self-employment income, and so forth).

Due to the vacation home profit, your net investment income will be $650,000 (from the sale) and your MAGI will $800,000 ($650,000 from the vacation home plus $150,000 from other sources). You would owe the 3.8 percent tax on $550,000, which is the lesser of: your net investment income of $650,000 or your excess MAGI of $550,000. In this case, that means $800,000 minus the $250,000 threshold for joint-filing couples. The 3.8 percent tax would amount to $20,900 (3.8 percent times $550,000). Ouch!

In this example, the sole source of your exposure to the tax is the vacation home gain. Therefore, consider the following strategies:

  • Sell the vacation home on an installment plan to spread the gain over several years and thus minimize or maybe even eliminate exposure to the tax.
  • If possible, swap the vacation home in a Section 1031 “like-kind exchange,” which would defer the big gain and completely eliminate your exposure to the 3.8 percent tax for now.
  • Take other steps (described below) to reduce your net investment income, which would reduce your exposure to the tax.

lores_heart_dollar_gift_mbStrategies to Reduce Net Investment Income and MAGI

  • Sell loser securities held in taxable accounts to offset earlier gains from such accounts.
  • Gift soon-to-be-sold appreciated securities to children or grandchildren and let them sell the securities to avoid including the gains on your return. But beware of the Kiddie Tax, which can potentially apply until the year your child or grandchild turns age 24. Talk with your tax adviser to ascertain if the Kiddie Tax might be an issue in your case.
  • Instead of cash, gift appreciated securities to IRS-approved charities. That way, the gains won’t be included on your return.
  • If possible, defer gains subject to the 3.8 percent tax by making installment sales or Section 1031 like-kind exchanges.

lores_rental_property_residential_home_real_estate_mbStrategies to Reduce Net Investment Income

  • Select a method for determining deductions allocable to gross investment income that will maximize such deductions and thereby reduce your net investment income. Your tax adviser can help find the best method.
  • If possible, become more active in rental and business activities (including those conducted through partnerships and S corporations) to “convert” them from passive to non-passive by meeting one of the material participation standards. That would make income from the activities exempt from the 3.8 percent tax, because it doesn’t apply to income from non-passive business activities (including non-passive rental activities). Ask your tax adviser for details.
  • To facilitate the preceding strategy, consider taking advantage of the one-time opportunity to regroup activities for purpose of applying the passive activity rules. Once again, your tax adviser can provide details.

Strategies to Reduce MAGI

  • Maximize deductible contributions to tax-favored retirement accounts such as traditional IRAs, 401(k) accounts, self-employed SEPs, and self-employed defined benefit pension plans. Note: You can make a deductible contribution to a traditional IRA right up until the April 15, 2014 filing date and still benefit from the resulting tax savings on your 2013 return. Small business owners can set up and contribute to a Simplified Employee Pension (SEP) plan for 2013 up until the 2014 due date for their returns, including extensions.
  • If you’re a cash-basis self-employed individual, defer business income into 2014 and accelerate business deductions into 2013. Consult with your tax adviser for specific information.


lores_tax_reduction_push_reduce_mbFive Long-Term Strategies to Avoid or Reduce the New Tax

The following ideas may not reduce or eliminate this year’s exposure to the new 3.8 percent Medicare tax, but they could help a lot over the long run.

  1. Convert traditional retirement account balances to Roth accounts, but watch out for the impact on your MAGI in the conversion year. That’s because the deemed taxable distributions that result from Roth conversions aren’t included in your net investment income figure, but they increase MAGI, which may expose more of your investment income to the 3.8 percent tax.  Over the long haul, however, income and gains that build up in a Roth IRA will usually avoid the 3.8 percent tax, because qualified Roth distributions are tax-free. Because qualified distributions are not included in your MAGI (unlike the taxable portion of distributions from other types of tax-favored retirement accounts and plans), they will not increase your exposure to the 3.8 percent tax by increasing your MAGI.
  2. Invest taxable accounts in tax-exempt bonds. This would reduce both net investment income and MAGI. Use tax-favored retirement accounts to invest in securities that are expected to generate otherwise-taxable gains, dividends, and interest.
  3. Invest in life insurance products and tax-deferred annuity products. Life insurance death benefits are generally exempt from federal income tax and are thus exempt from the 3.8 percent Medicare tax too. Earnings from life insurance contracts are not taxed until they are withdrawn. Similarly, earnings from tax-deferred annuities are not taxed until they are withdrawn.
  4. Invest in rental real estate and oil and gas properties. Rental real estate income is offset by depreciation deductions, and oil and gas income is offset by deductions for intangible drilling costs (IDC) and depletion. These deductions can reduce both net investment income and MAGI.
  5. Invest taxable accounts in growth stocks. Gains are not taxed until the stocks are sold. At that time, the negative tax impact of gains can often be offset by selling loser securities held in taxable accounts. In contrast, stock dividends are taxed currently, and it may not be so easy to offset them.

Proactive Planning Can Pay Off

Some of the strategies described above, and in the right-hand box, are doubly effective because they can reduce your regular federal income tax bill as well as the 3.8 percent Medicare tax. If you’re self-employed, some of the ideas can amount to tax-saving triple plays because they can also reduce your self-employment tax bill. Finally, they might reduce your state income tax bill as well. However, some of these strategies take time to implement. So talk with your tax adviser now. Waiting until later in the year could prove to be too late.

Read more from the Anderson ZurMuehlen blog



Beware of the AMT when doing year-end tax planning

As year end approaches, you may be trying to accelerate deductible expenses into 2013 to reduce, or at least defer, tax. But you must beware of the alternative minimum tax (AMT) — a separate tax system that limits some deductions and doesn’t permit others, such as:

• State and local income tax deductions,

• Property tax deductions, and

• Miscellaneous itemized deductions subject to the 2% of adjusted gross income floor, such as investment expenses and unreimbursed employee business expenses.

Accelerating these expenses could trigger the AMT, because you must pay the AMT if your AMT liability exceeds your regular tax liability.

The American Taxpayer Relief Act of 2012 (ATRA) set higher AMT exemptions permanently, indexing them — as well as the AMT brackets — for inflation going forward. This will provide some AMT relief, but higher-income taxpayers could still be vulnerable.

We’d be happy to help you determine whether accelerating deductible expenses will reduce your 2013 tax bill — or could trigger the AMT. Contact Patty Nelson, Shareholder, at 406.442.1040.

Copyright ©Thomson Reuters

Read more from the Anderson ZurMuehlen blog



2013 may be your last chance for a “charitable IRA rollover”

If you’re age 70½ or older, you can make a direct contribution — up to $100,000 — from your IRA to a qualified charitable organization in 2013 without owing any income tax on the distribution. This “charitable IRA rollover” can be used to satisfy required minimum distributions.

The American Taxpayer Relief Act of 2012 (ATRA) revived this opportunity, but only for 2012 and 2013. So if you’d like to make a charitable IRA rollover, consider doing so this year in case the opportunity isn’t extended. If you already took advantage of the ATRA provision that allowed a charitable rollover made in January 2013 to be treated for tax purposes as if it had been made Dec. 31, 2012, you can make another $100,000 rollover this year for 2013 tax purposes.

Have questions about charitable IRA rollovers or other giving strategies? Contact Cindy Utterback, Shareholder, at 406-442-1040. We can help you create a giving plan that will meet your charitable goals and maximize your tax savings.

Copyright ©Thomson Reuters

Read more from the Anderson ZurMuehlen blog


Even with rising exemptions, 2013 annual exclusion gifts still a good idea

Recently, the IRS released the 2014 annually adjusted amount for the unified gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption: $5.34 million (up from $5.25 million in 2013). But even with the rising exemptions, making annual exclusion gifts is still a good idea.

The 2013 gift tax annual exclusion allows you to give up to $14,000 per recipient tax-free — without using up any of your gift and estate or GST tax exemption. (The exclusion remains the same for 2014.)

The gifted assets are removed from your taxable estate, which can be especially advantageous if you expect them to appreciate. That’s because the future appreciation can avoid gift and estate taxes.

But you need to use your 2013 exclusion by Dec. 31. The exclusion doesn’t carry over from year to year. For example, if you and your spouse don’t make annual exclusion gifts to your granddaughter this year, you can’t add $28,000 to your 2014 exclusions to make a $56,000 tax-free gift to her next year.

Please contact Bill Hughes, Shareholder,  for ideas on how to make the most of annual exclusion gifts.

Copyright ©Thomson Reuters

 Read more from the Anderson ZurMuehlen blog



Re-incorporating in a New State Can Be Costly

By Shirlee Walker, Shareholder

Revenue Rule 67-390 makes it clear that “an exempt organization incorporated under the laws of one state” and then “reincorporated under the laws of another state with no change in its purposes” is a new legal entity.  This new entity must apply for an exemption and cannot qualify under the old entity’s exempt status.  If the new entity does not apply for exempt status, donor contributions will not be deductible and the organization will be required to file Form 1120, U.S. Corporation Income Tax Return.  This ruling has been cited in an IRS exemption revocation as recently as 2012. 

In 2003, the Advisory Committee on Tax Exempt and Government Entities addressed the requirement to file for a new tax exempt status when an exempt organization relocates to a new state.  The committee concluded it would be difficult to ensure that no other changes had taken place in the re-incorporation and recommended no change in the process.  The committee did state that a “new” organization reincorporating under these circumstances should be able to obtain a definitive public support ruling based on the financial data of the “old” organization.  The committee pointed out that if an exempt organization moves to a new state without reincorporating, the organization is not required to file a new exemption application.  In this case, the organization would maintain its incorporation in the old state as a domestic corporation and register in the new state as a foreign corporation. 

The American Bar Association (ABA) Section of Taxation asked the IRS to address this issue in the 2012-2013 Treasury-IRS Guidance Priority List.  The ABA requested that the IRS provide guidance on how to obtain a revised determination letter without having to file a new exemption application when there is a mere change in the form or state of incorporation.  The IRS did not include this issue in the Guidance Priority List.

This brings up another question.  Revenue Rule 67-390 is silent on the status of the old corporation’s Employer Identification Number (EIN).  Several sources believe the re-incorporated entity is required to obtain a new EIN.  Revenue Rule 73-526 indicates that when a corporation re-incorporates in a new state under a section 368(a)(1)(F) type of restructuring, the corporation should continue to use the same EIN.  Other rulings have made this same determination where for-profit corporations were involved. 

If your tax exempt organization is considering a move from one state to another, please contact Suzanne Severin, Shareholder, or Shirlee Walker, Shareholder to discuss your particular circumstances.

 Read more from the Anderson ZurMuehlen blog



Maximize your 2013 depreciation deductions with a cost segregation study

If you’ve recently purchased or built a building or are remodeling existing space, consider a cost segregation study. It identifies property components and related costs that can be depreciated much faster, perhaps dramatically increasing your current deductions. Typical assets that qualify include decorative fixtures, security equipment, parking lots and landscaping.

The benefit of a cost segregation study may be limited in certain circumstances, such as if the business is subject to the alternative minimum tax or is located in a state that doesn’t follow federal depreciation rules.

For more information on cost segregation studies — or on other strategies to maximize your 2013 depreciation deductions — contact Suzanne Severin, Shareholder,  at 406.442.1040.

Copyright ©Thomson Reuters

Read more from the Anderson ZurMuehlen blog

Pack the Place In Pink!

Will your exec comp be subject to expanded Medicare taxes?

Maybe. The following types of executive compensation could be subject to the health care act’s 0.9% additional Medicare tax:

• Fair market value (FMV) of restricted stock once the stock is no longer subject to risk of forfeiture or it’s sold

• FMV of restricted stock when it’s awarded if you make a Section 83(b) election

• Bargain element of nonqualified stock options when exercised

• Nonqualified deferred compensation once the services have been performed and there’s no longer a substantial risk of forfeiture

And the following types of gains will be included in net investment income and could trigger or increase exposure to the act’s new 3.8% Medicare contribution tax:

• Gain on the sale of restricted stock if you’ve made the Sec. 83(b) election

• Gain on the sale of stock from an incentive stock option exercise if you meet the holding requirements

We’d be happy to help you determine the best strategy for your exec comp. With smart timing, you may be able to reduce or avoid exposure to the expanded Medicare tax.

Copyright ©Thomson Reuters

Read more from the Anderson ZurMuehlen blog


Why you should max out your 2013 401(k) contribution

Contributing the maximum you’re allowed to an employer-sponsored defined contribution plan, such as a 401(k), 403(b) or 457 plan, is likely a smart move:

• Contributions are typically pretax, reducing your modified adjusted gross income (MAGI), which can also help you reduce or avoid exposure to the new 3.8% Medicare tax on net investment income.

• Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.

• Your employer may match some or all of your contributions pretax.

For 2013, you can contribute up to $17,500 — plus an additional $5,500 if you’ll be age 50 or older by Dec. 31.

If you participate in a 401(k), 403(b) or 457 plan, it may allow you to designate some or all of your contributions as Roth contributions. While Roth contributions don’t reduce your current MAGI, qualified distributions will be tax-free. Roth contributions may be especially beneficial for higher-income earners, who are ineligible to contribute to a Roth IRA.

 Read more from the Anderson ZurMuehlen blog

Family Enterprise Montana Forum on October 18th in Missoula

The inaugural 2013 Family Enterprise Montana Forum, hosted by the Missoula Economic Partnership and The University of Montana’s School of Business Administration, is designed to provide unique learning experiences to those involved with family business throughout Montana.

The Forum is scheduled for Friday, October 18th at the Holiday Inn, Missoula Downtown and the cost is $45.

Find out more.

Read more from the Anderson ZurMuehlen blog