There are now two more taxes for tax practitioners to consider while planning for their clients’ year-end liability. The recently passed 2010 health care reform legislation (the Patient Protection and Affordable Care Act, P.L. 111-148, and the Health Care and Education Reconciliation Act, P.L. 111-152) added two additional Medicare taxes intended to help pay for the new legislation. This item looks at the details of both the 3.8% investment income tax and the 0.9% hospital insurance tax increase and reviews some of the effects they will have on estimated taxes and tax planning.
Medicare Investment Income Tax
The details of the Medicare investment tax are not nearly as complicated as are many of the other provisions of the new laws. In brief, starting in 2013 there will be a 3.8% tax levied on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount. The threshold is $250,000 for married couples filing jointly, $125,000 for married filing separately, and $200,000 for all other returns.
One result of the new tax is an increase in the marriage penalty. Two cohabitating single taxpayers can earn $200,000 each for a total of $400,000 before reaching the threshold, while married couples will reach $250,000 sooner, which complicates the calculation of estimated taxes for married couples (explained below).
The tax is focused solely on investment income. A taxpayer with no investment income will not owe the additional 3.8% regardless of how much his or her MAGI exceeds the threshold. On the other hand, a single taxpayer with MAGI of less than $200,000 will not pay the additional 3.8% even if his or her entire earnings consist of only investment income.
Example 1: J, a single taxpayer who has MAGI of $230,000 and investment income of $50,000, will owe $1,140 (0.038 × $30,000). The charge is 3.8% on the lesser of his investment income ($50,000) or his MAGI in excess of $200,000 ($30,000). However, if J has MAGI of $230,000 but has investment income of only $20,000, he will owe $760 (0.038 × $20,000), calculated as 3.8% of the lesser of investment income (now $20,000) or MAGI in excess of $200,000 ($30,000).
The definition of investment income includes such items as interest, dividends, and capital gains, as might have been expected. Investment income will also include annuities, royalties, and any income that would fall under the passive activity rules of Sec. 469, including rents and income from trading in financial instruments or commodities. Gains from the sale of a home that are excluded from income under Sec. 121 will not be considered investment income; however, any gain above the Sec. 121 exclusion ($250,000 for singles and $500,000 for married couples filing jointly) will be included. Therefore, if clients are expecting to sell a personal residence within the next few years and will have gains above the Sec. 121 exclusion, it may be wise to advise them to sell before the end of 2012. The tax will also apply if they decide to sell a second or vacation home. The sale of a passive investment in an S corporation or a partnership will be considered investment income to the extent that there would have been gain if the property inside the entity had been sold at fair market value immediately before the disposition.
Other items of income have been specifically excluded from the definition of investment income. These include such sources as qualified retirement plan distributions, tax-exempt bond interest, or any activity that would qualify as self-employment income. It is important to note that while distributions from qualified retirement plans do not qualify as investment income, they may increase MAGI, which in certain situations will have the effect of increasing the amount of investment income subject to the tax, as shown in Example 2.
Example 2: If the taxpayer in Example 1 with MAGI of $230,000 and investment income of $50,000 now decides to take a qualified IRA distribution of $10,000, his MAGI will increase from $230,000 to $240,000. Although the distribution is not subject to the Medicare tax, an additional $10,000 of his investment income, now $40,000 MAGI over $200,000 instead of $30,000, will be taxed.
This result may make investments in Roth accounts more attractive because qualified distributions are not taxable and therefore do not increase MAGI. If a client is considering rolling over a regular IRA into a Roth, he or she should attempt to do so before 2013 in order to lessen MAGI after 2012.
Someone who meets the definition of a real estate professional will not be subject to the tax on his or her income from real estate activities because this constitutes income from an active trade or business, which is specifically excluded from the definition of investment income. A person who has a regular day job but also manages rentals that he or she owns will be subject to the tax on his or her income from the real estate activity because of the presumed passive nature of rental activities. The real estate professional is not completely in the clear, though, due to the possibility of being subject to the 0.9% hospital insurance tax on self-employment income discussed later.
Tax advisers must take all these items into consideration when planning for clients’ estimated taxes. The additional tax is subject to the rules and penalties that apply to regular estimated tax requirements. The new Medicare tax is not set to be indexed for inflation. This means that as inflation increases and salaries grow, more and more taxpayers will be subject to the tax, even though their expendable income may not have increased.
One bright point to keep in mind during planning is that the tax is levied against net investment income. This provides an opportunity to make use of the passive losses clients are accumulating. Clients can use passive losses from a partnership or S corporation to offset interest, dividends, or passive income earned elsewhere. They can also use harvesting investment losses as a technique to minimize investment income during years that clients have substantial passive or other investment income. The passive losses, of course, can only be used to offset investment income that would otherwise qualify for the additional 3.8% Medicare tax, and they do not affect regular taxes.
Hospital Insurance Tax
A second provision of the legislation is an increase in the hospital insurance tax. Beginning in 2013, an additional 0.9% Medicare tax will be levied on wages and self-employment income in excess of a threshold. The income threshold is set at the same amounts as the investment income tax: $250,000 for married filing jointly and $200,000 for single filers. This tax is in addition to the 3.8% tax on investment income, meaning that taxpayers who have high investment income as well as high wages or self-employment income may be subject to both taxes. The increase in tax is attributable only to the employee portion and does not affect the amount the employer is required to pay, although the employer is required to withhold the additional amount.
The process of withholding could be problematic in calculating estimated taxes for clients because employers are only required to withhold the 0.9% after a taxpayer reaches the $200,000 mark, without regard to the income of his or her spouse. While this has no effect on the single taxpayer, a married couple may easily be underwithheld if their combined income is more than $250,000 but neither makes more than $200,000 individually.
Example 3: Husband and wife P and Q each make $200,000 at separate places of employment. Neither of them has additional amounts withheld automatically because both are below the single filer threshold. However, P and Q will now owe an additional $1,350 (0.009 x $150,000) in estimated taxes because their combined income is $400,000, $150,000 above the married filing jointly threshold.
The hospital insurance tax, like the investment income tax, is not indexed for inflation. To make matters worse, the increase of 0.9% is not used in calculating the one-half of self-employment tax deduction taken on page 1 of Form 1040, U.S. Individual Income Tax Return. A single taxpayer will now pay self-employment tax of 2.9% on the first $200,000 of self-employment income and 3.8% on any remaining self-employment income above the $200,000 threshold. The deduction, however, will be calculated without regard to the additional 0.9% by taking half of the original 2.9% instead of half of the amount actually paid.
The start date of 2013 is still more than two years away, and more than a little could change between now and then. Tax advisers will have to wait and see how the next few years play out to find out whether the Medicare tax will in fact be implemented. However, until something changes, advisers need to be aware of the tax and how it will affect their clients.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
For additional information about these items, contact Mr. Koppel at (781) 407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.