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Portfolio > Economy & Markets > Fixed Income

Estate Planners: 5 New Taxes to Watch

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Now that the health care law has been declared constitutional, the remaining provisions will be going into effect. This includes several significant provisions that become effective on Jan. 1. (Yes, there is the possibility of repeal if the Republicans win the presidency and elect a majority in both the House and Senate in November, but we have to plan based on what we know, not what we think could happen. And for now, the health care law is the law of the land.)  

See also: Midyear Tax Checkup Makes Extra Sense This Year

Tax #1: 3.8% surtax on investment income

This new tax will be levied on your net investment income if your modified adjusted gross income is more than a certain amount, called the “threshold amount.” For married taxpayers filing jointly, the threshold amount is $250,000. For married taxpayers filing separately, it’s $125,000. For all other single taxpayers, the threshold is $200,000. The surtax also applies to trusts and estates if the net investment income is more than about $12,000 and is not paid out to the heirs/beneficiaries. 

Assuming Congress extends the current tax rates, which are set to expire Dec. 31, adding this surtax will increase the tax rate on long-term capital gains and dividends from 15% to 18.8%. If Congress does not extend the current rates, the top rate on Jan. 1 for capital gains will be 23.8%, and the top dividends rate will be a whopping 43.4%.  

How is the tax determined? Your modified adjusted gross income is your adjusted gross income (the last line on page 1 of Form 1040) plus the net foreign income exclusion amount. Income includes interest, dividends, capital gains, wages, retirement income, and income from businesses and partnerships. No itemized deductions, which lower your income for income tax purposes, are included for this calculation. If your modified adjusted gross income is less than or equal to the threshold amount for your taxpayer status (above), then you will not pay the surtax, regardless of how much investment income you have. If your modified adjusted gross income is more than your threshold amount, you will pay the 3.8% surtax on 1) the amount of your adjusted gross income over the threshold amount; or 2) your net investment income, whichever is less

Example 1: A married couple filing jointly has $280,000 in salaries and $60,000 in net investment income, resulting in adjusted gross income of $340,000 — $90,000 over their threshold amount. Because their net investment income is less than the amount over the threshold, they will pay surtax on $60,000 of investment income, or $2,280.  

Example 2: A single taxpayer has $150,000 in salary and $40,000 in net investment income. The 3.8% surtax will not apply because he has less than $200,000 in adjusted gross income.

Example 3: A married couple filing jointly has $400,000 in salaries and no net investment income. They will pay no surtax because the amount of their net investment income ($0) is less than the amount over their threshold.  

Example 4: An estate has net investment income of $200,000 but it distributes all of the income to the heirs. The estate will not pay a surtax, and each heir will count the income distribution toward his/her own surtax calculation.

What is net investment income? Net investment income is total investment income less allocable expenses. Investment income includes interest, dividends, capital gains, annuities, rents, royalties, passive activity income, gain on the sale of a principal residence above the $250,000/$500,000 exclusion, and gain from the sale of a second home. It does not include active trade and/or business income; distributions from IRAs and other qualified retirement plans; Social Security income and veterans’ benefits; income from tax-exempt and tax-deferred vehicles like municipal bonds, tax-deferred nonqualified annuities, life insurance and nonqualified deferred compensation; or any income taken into account for self-employment tax purposes.

How can I minimize the tax? Remember there are two parts to this formula — modified adjusted gross income and net investment income. The surtax will only apply to investment income above the threshold, but other income can increase your adjusted gross income and cause your investment income to be exposed to the tax. Start now to reduce your investment income and modified adjusted gross income for 2013 and beyond. Consider shifting investments, converting to a Roth IRA, deferring income, increasing contributions to tax-deferred plans, installment sales and charitable trusts.  

Tax #2: Medicare payroll tax increase

The Medicare tax will increase 0.9%, from 1.45% to 2.35%, on wages and self-employment income above $250,000 for married taxpayers filing jointly and above $200,000 for single taxpayers. For a married couple earning $300,000 in combined income, this will mean an additional $450 in Medicare taxes starting in 2013. There is no cap on this tax, so it applies to whatever amount you earn above the threshold. Beyond the threshold, employers will continue to pay at the 1.45% rate, but self-employed taxpayers will pay at a rate of 3.8%.

Tax #3: Medical device manufacturing tax

This 2.3% tax will be levied on the gross sales of medical device makers (whether or not they make a profit) and will undoubtedly be passed on to consumers who buy their products.  

Tax #4: High medical bills tax

Currently, medical expenses that exceed 7.5% of your adjusted gross income are deductible on your Form 1040. On Jan. 1, the threshold will increase from 7.5% to 10%, increasing the amount you will pay in taxes.  

Tax #5: Flexible spending account cap

Flexible spending accounts are pre-tax accounts that 24 million Americans use to pay for all kinds of family medical expenses, including tuition for children with special needs. Currently, these accounts have no federal limit, but beginning Jan. 1, they will have a $2,500 annual cap.  

In addition to planning now to reduce or avoid the 3.8% surtax in 2013 and beyond, this is an exceptional year for clients and prospects to do estate planning. The federal gift and estate tax exemption is $5.12 million, which allows a married couple to remove as much as $10.24 million from their estate with no estate tax. Under current law, this exemption is scheduled to shrink to $1 million in 2013. Other Bush-era tax rates, including income and capital gain taxes, are set to expire at the end of 2012. With these new taxes becoming effective in January, 2013 is on track to have the highest tax rates we have seen in years.

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For more on estate taxes, see:

Adding Values to the Boomer Estate Plan

Advisors, Use This Wealth Transfer Strategy While You Can

Estate Planning: Focus on the Legacy, Not the Tax Bill


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