A Future Tax May Hit Unearned Income - January 2011
Richard Scrivanich - Partner

Although major provisions of the new health care reform passed earlier this year won't take effect until 2014, you may be affected by significant tax increased before then. One of these tax increased is a 3.8% tax (described as a Medicare contribution) on some taxpayers' unearned income, starting in 2013.

Two thresholds
This 3.8% tax will affect taxpayers whose modified adjusted gross income (MAGI) exceeds certain amounts. MAGI, for this purpose, will be the adjusted gross income (AGI) you report on the bottom of page 1 of IRS Form 1040 or For 1040A (on line 4 of Form 1040EZ), plus any foreign income you exclude in calculating AGI. If your MAGI is nor more than $200,000 as single filer, or no more than $250,000 o a joint return, you will not be subject to this 3.8% tax. (These two MAGI thresholds will not be indexed for inflation.

If your MAGI is over the relevant threshold, you'll probably owe the 3.8% tax. Here's how to calculate your obligation:

1. Determine your net investment income. For a given calendar year, add up your taxable interest, dividends, capital gains, rents, royalties, ordinary income and capital gains from passive activities (such as rental real estate activities) or financial instrument or commodities trading business, and taxable payouts from annuities. Then subtract any deductions allocated to that income, such as interest on margin loans.
2. Determine the extent to which your MAGI exceeds the relevant threshold.
3. You will owe 3.8% tax on the lower number, (1) or (2).

Do the math
Some examples will illustrate the above calculation.

Example 1: John Jones, a single filer, has MAGI of $220,000 in 2013. His net investment income is $50,000. John's MAGI is over the $200,000 threshold by $20,000. Here, John's MAGI threshold overage of $20,000 is less than John's investment income of $50,000. Thus, John will owe a 3.8% tax on $20,000 $760.

Example 2: Amelia and Bart Dugan have a MAGI of $310,000 in 2013. Their net investment income is $50,000, the same as John Jones. However, the Dugans are $60,000 over the $250,000 threshold for their joint MAGI. The Dugans' investment income of $50,000 is less than their income threshold overage of $60,000. Therefore, the Dugans will owe the 3.8% tax on all $50,000 of their net investment income, $1,900.

Tax trimming tactics
Two ways exist for high income taxpayers to avoid or reduce their exposure to this 3.8% tax. First, you can trim your net investment income. You might invest in tax-exempt municipal bonds or no dividend growth stocks, for example. The less investment income you have, the lower your potential tax obligation.

Second, you can minimize your MAGI. Tax deductible contributions to retirement plans, for example, may be able to hold your MAGI below or modestly above the relevant threshold and reduce the amount you'll owe under this 3.8% tax.

As mentioned, this tax won't be effective until 2013. Therefore, you have more than two years to arrange tax reduction strategies. In 2010, though, you might consider a Roth IRA conversion as a means of reducing the amount of this 3.8% tax you'll owe in the future.

With a Roth IRA, distributions are completely tax free after five years and after age 59 ½. Depending on your age, you might be able to take tax-free Roth IRA distributions as early as 2015 if you convert in 2010. (If you previously had a Roth IRA, the conversion starts a new five-year clock so you will have to wait those five years until investment earnings from the converted dollars can come out tax free.) Tax-free Roth IRA distributions are not considered investment income and will not boost your MAGI. Therefore, they will not trigger the 3.8% tax in 2013 and later years.

Converting to a Roth IRA does trigger income tax. If you convert in 2010, you'll pay tax at today's rates, no higher than 35%. That may be better than taking taxable distributions or converting in the future when you may owe higher income tax rates and when distributions or conversions might raise your MAGI and thus cause a 3.8% surtax as well.

What's more, you'll get the greatest advantage from a Roth IRA conversion if you pay the resulting tax from non-IRA funds. If you draw down your taxable investments to pay the tax, you may have less investment income in the future and thus owe a smaller amount of the new 3.8 tax.

If you have any questions regarding the above discussed topic or any other tax matter, please feel free to give me a call at (562) 698-9891.