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Articles: Five ways to reduce new surtax

Certain high-income investors may be liable for a new 3.8% Medicare surtax on investment income in 2013. Unlike other tax changes in the American Taxpayer Relief Act of 2012 (ATRA) taking effect this year, this provision was part of the Patient Protection and Affordable Care Act of 2010 (PPACA). With some astute planning, you may be able to reduce the surtax you owe in 2013, or even eliminate it.

Basic premise:  The 3.8% Medicare surtax applies  to the  lesser  of your “net investment income” (NII) or the
amount  by  which  your  modified  adjusted  gross  income (MAGI) exceeds $200,000 for single filers and $250,000 for joint  filers.    For  example,  if  you  are  a  single  filer  with $150,000 in NII and a MAGI of $300,000 in 2013, the sur-tax is $3,800 (3.8% of $100,000 excess MAGI).  Now that ATRA has increased the top income tax rate to 39.6% in 2013, you could pay a combined federal tax rate of 43.4% (39.6% + 3.8%) on certain income.

The PPACA definition of NII includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities, and income from the trading of financial instruments or commodities.  But certain other items -such as wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a nonpassive business, and distributions from qualified retirement plans and IRAs -are excluded.

Consider strategies that may reduce your exposure to the new surtax.   Here are five possibilities.

  1. Municipal bonds:  The income from tax-exempt municipal bonds does not count toward NII or MAGI.  So adding (“munis”) to your portfolio -or increasing your current investment in munis -is often a good way to decrease liability for the 3.8% surtax. Of course, you do not want to go overboard with any one investment, so plan accordingly.

  2. Roth conversion: By converting funds in a traditional IRA to a Roth, you can seek tax protection in future years. For a Roth in existence at least five years, qualified distributions (e.g., those made after age 59½) are 100% tax-free. This sidesteps the surtax problem in the future.

  3. Passive activities:    NII includes amounts generated by passive  activities  such  as  rental real estate. Therefore, if you own a business interest where you do not take an active role, you might have to pay the surtax.  However, if you “materially participate” in the business, the income generally will not count as NII. Caution: Special rules apply to rental real estate activities.

  4. Charitable remainder trusts:  With a charitable remainder trust (CRT), you can generally claim a current tax deduction for the gift of the remainder interest, while receiving income for a period of years or your lifetime.  The CRT can help avoid the surtax on highly appreciated capital gains. Obtain professional guidance for these trusts.

  5. Annuities:  By investing in a tax-deferred annuity, you can arrange to receive payments in retirement, while “leapfrogging” high-income years when you might be liable for the 3.8% surtax.  This tax-deferral strategy may be advantageous if you expect to be in a lower tax bracket in retirement than you are now.

Of course, you don’t have to go it alone.  Seek professional guidance concerning tax and financial matters.

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