By Robert S. Keebler, CPA, MST, AEP (Distinguished)

As you probably know all too well, tax rates increase substantially in 2013 and later years for high income taxpayers. Not only did the top income tax rate increase from 35% to 39.6%, but a 3.8% Medicare surtax is now imposed on net investment income (NII). The 39.6% rate now applies to taxable income over $450,000 for married taxpayers and $400,000 for single taxpayers. In addition, net investment income is subject to a new 3.8% Medicare surtax to the extent modified adjusted gross income exceeds $250,000 for married taxpayers and $200,000 for single taxpayers. Together, the 39.6% rate and the 3.8% Medicare surtax could increase your clients’ effective tax rate to as much as 43.4%.

The increased tax rates make managing income from year to year more important than ever. Fortunately, there are a number of strategies you can use to help your clients stay out of the top marginal bracket and/or eliminate or reduce their surtax exposure. These include (1) charitable remainder trusts (CRTs) to smooth income, (2) CRTs to shift income, (3) CRTs to save for retirement. (4) charitable lead trusts, (5) life insurance, (6) deferred annuities, (7) installment sales, (8) managing IRA distributions. (9) gain harvesting,  (10) loss harvesting, (11) Roth IRA conversions, (12) converting passive activities to active activities by changing grouping elections, (13) private split dollar insurance, (14) reverse mortgages, (15) low NII investments, (16) real estate investments, (17) oil and gas investments, (18) choice of filing status and   increasing above-the-line deductions.

Beginning with next month’s newsletter, I will be discussing one or more of these strategies in more detail each month. To set the stage, however, I will briefly lay out how the surtax works in this issue.

Overview of the 3.8% Medicare Surtax

For individuals, the surtax applies to the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over an applicable threshold amount (ATA).[1]

NII

NII is the sum of three kinds of income reduced by deductions properly allocable to them:

1. Gross income from interest, rents, dividends, annuities and royalties unless such income is derived in the ordinary course of an active trade or business other than a securities or commodities business;
2. Gross income from a trade or business that is either (a) a passive activity for the taxpayer under IRC § 469 or (b) a financial instruments or commodities business; and
3. Net gain (to the extent taken into account in calculating taxable income) attributable to the disposition of property other than property held in an active business that is not a securities or commodities business.[2]

The following items of income are specifically excluded from NII:

• Distributions from Roth IRAs
• Distributions from traditional IRAs
• Distributions from 401(k) plans
• Social security
• Life insurance proceeds
• Municipal bond interest
• Schedule C income from businesses
• Income from a business in which the taxpayer pays self-employment tax
• Veterans’ benefits
• Deferred compensation

MAGI
MAGI is adjusted gross income (AGI) increased by net foreign-source income exempt from regular tax under IRC section 911(a)(1). For most taxpayers, MAGI is simply the amount reported on line 37 (bottom of Page 1) of Form 1040.

ATA Amounts
The applicable threshold amounts are as follows:

• Married taxpayers filing jointly………………………..$250,000
• Married taxpayers filing separately……………………$125,000
• All other individual taxpayers………………………….$200,000

A simple example will illustrate how the surtax is calculated.

Example. Ron is a single taxpayer with the following items of income:

• $150,000 salary
• $50,000 Roth distribution
• $60,000 traditional IRA distribution
• $10,000 of dividends
• $5,000 of interest income
• $100,000 gain on the sale of publicly-traded stock

Ron is subject to the surtax on the lesser of NII or the excess of MAGI over the ATA of $200,000 for a single taxpayer.

The following items of income are included in MAGI:

• Salary………………………………………………………………….$150,000
• Traditional IRA distribution……………………………………………60,000
• Dividends……………………………………………………………….10,000
• Interest…………………………………………………………………..5,000
• Gain on the sale of stock……………………………………………$100,000
• Total MAGI……………………………………………………………$325,000
  (MAGI in excess of $200,000 ATA = $125,000)

These items are included in NII:

• Dividends……………………………………………………………….10,000
• Interest…………………………………………………………………..5,000
• Gain on sale of stock…………………………………………………$100,000
• Total NII……………………………………………………………….$115,000

Thus, the lesser of NII and MAGI – ATA is $115,000 and the surtax payable is $4,370 (.038 x $115,000). Note that the Roth distribution is neither MAGI nor NII. Note also that although the traditional IRA is not NII, it increases the surtax payable by increasing MAGI. Without the traditional IRA distribution, MAGI – ATA would be only $265,000 – $200,000 = $65,000, and the amount subject to the surtax would be only $65,000 instead of $115,000.

NEXT MONTH

In the next newsletter, we will show how charitable remainder trusts can be used to smooth out income, keeping taxpayers out of the top marginal tax brackets and/or eliminating or reducing their surtax payable.

RELATED TRAINING & EDUCATION
In the past few months, Mr. Keebler has presented a number of timely and  helpful educational programs that may be of interest to you including, but not limited to:

• Fiscal Cliff Legislation and What it Means for your Clients      
• Taxation of Trusts and Estates After the New Tax Law
• The Top 10 Hottest Estate Planning Ideas for 2013

You can download the handout materials and the audio recording to these programs.  Also, take a look at the list of Upcoming Programs to see other related programs we have coming up with Mr. Keebler.

ABOUT THE AUTHOR

Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States.  Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters.  He can be reached at (920)593-1701 or at robert.keebler@keeblerandassociates.com.