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Getting ready for the Medicare tax on investment income

Getting ready for the Medicare tax on investment income

There are few certainties for year-end tax planning this year, but if you're a wealthy investor there is one sure thing — the new Medicare tax, slated to begin in 2013.

Part of the 2010 health care reform law, it is a 3.8 percent tax on investment income for individuals with adjusted gross income above $200,000, or $250,000 for married couples filing jointly. The same high-income taxpayers will also face an additional Medicare tax of 0.9 percent on wages and self-employment income, on top of the Medicare tax they currently pay.

"This is very real," says Robert Keebler, a partner at Keebler & Associates, a tax and estate planning firm in Green Bay, Wisconsin, who recently wrote a book on the Medicare tax for tax research firm CCH. "People are still in denial, but this is starting to change."

Workers already pay 1.45 percent of their pay in Medicare taxes. Employers also pay 1.45 percent, but won't be required to pay half of the new 0.9 percent additional tax.

The new Medicare tax is structured as a surcharge on net investment income including capital gains, dividends, interest, royalties, partnerships and trusts. The tax does not apply to tax-exempt income, such as interest from municipal bonds, or distributions from retirement plans. The rules are complex; on Monday the Internal Revenue Service issued a 159-page proposed rule designed to clarify the tax.

Depending on how much you make from wages and investments, the surcharge could apply to all of your investment income or only to part of it.

To understand how the tax works consider two examples, included in a Wells Fargo Advisors explainer on the issue. Couple A has wages of $230,000 and capital gains of $30,000, for a total of $260,000; they're $10,000 over the threshold, so would owe 3.8 percent of that excess, or $380, for the Medicare tax. Couple B has wages of $350,000 and investment income of $35,000; they would owe 0.9 percent on the $100,000 in wages over the threshold (or $900), plus 3.8 percent on their investment income (or $1,330), for a total of $2,230.

These new Medicare taxes, coupled with the slated expiration of the George W. Bush-era tax cuts at the end of this year, have accountants and tax advisers preparing for a flurry of activity from their wealthy clientele.

For high earners, the combination of the Medicare tax and an expected higher capital gains rate could result in an effective long-term capital gains rate of 23.8 percent, versus today's low rate of 15 percent.

If you're lucky enough to be above the threshold, here's how to think about your planning over the next few weeks.


If you expect to be above the Medicare tax threshold and think your capital-gains rate will be higher in 2013, that turns traditional tax-loss harvesting on its head. Instead of the typical strategy of taking capital losses at year-end, you'll want to take gains and defer losses — you can lock in the gains at 15 percent this year, versus potentially paying 23.8 percent next year.

If you have stocks with substantial gains in your taxable portfolio, you could even choose to lock in the 15 percent tax on those gains, then buy back the same stock over the coming months in order to reset your cost basis for tax purposes before rates go up. (The so-called wash sale rule, which prohibits immediately buying the same shares back when you take a loss, doesn't apply to gains.) Ideally, you'll want to pay for the tax outside of the investment you sold so as to keep the amount invested the same.


Medicare surcharge strategies get more complex for those who have trusts. Trusts are subject to the Medicare tax on the lesser of their undistributed net investment income for the year or the excess of their adjusted gross income over a threshold, currently $11,650. The result is that most trusts — with the exception of charitable trusts, which are exempt — will be affected by the new Medicare tax.

"The threshold is very low on trusts," says Ron Finkelstein, a tax partner at Marcum LLP in Melville, N.Y. "The threshold for trusts is much lower than for individuals."

One possible strategy for trusts: They may be able to reduce or eliminate the Medicare tax by distributing income to beneficiaries — especially if those recipients have income levels that put them below the cut-off for the Medicare tax.


Interest payments on intra-family loans, which have been quite popular among affluent families at a time of low rates, could also be subject to the Medicare tax for those receiving the loan repayment. That means that those parents who have used intra-family loans to help their kids without paying gift taxes may want to revisit those arrangements.

"Things that people have done in the past that were revenue-neutral, like intra-family loans, no longer are," says Paul Gevertzman, a tax partner at accounting firm Anchin, Block & Anchin, in New York. "What was a good plan two years ago isn't a good plan now. So either you want to undo it or lower the interest rate to the lowest allowable amount."


Increasing taxes on investments could prove a boon to insurance sales. That's because investment income that accrues within insurance products isn't subject to the same taxes — and death benefits are never taxed, Keebler says. While he's advising his clients to wait until the final regulations on the Medicare tax come out, he figures that insurance will be a good option for at least some of them.

Then again, when making investments, tax should always be a secondary reason for deciding what to do. As Anchin, Block & Anchin partner Laurence Feibel puts it: "Warren Buffett is right. No one chooses not to invest because the tax rate is 50 percent. That's the reality."

© Copyright 2012 Thomson Reuters.

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