Wealthy Widows Need to Plan for the New 3.8% Medicare Tax

 Bryan Wisda for Nerd Wallet writes: The new 3.8% Medicare Tax which took effect this year (part of ObamaCare) applies to unearned income.  Essentially this is a tax which applies to income earned by your investment portfolio. The tax only applies to those defined by the tax code as “high income” individuals.  For widows filing as single tax payers this tax will apply if your Adjusted Gross Income (AGI) is greater than $200,000 ($250,000 for joint tax payers).  Your AGI can be found on the last line of the first page of your federal tax return. This tax also applies to trusts and estates whose AGI is greater than $11,650 as of 2012.  Fortunately this tax only applies to trusts and estates on income which is not distributed to beneficiaries.

The 3.8% Medicare Tax only applies to the lesser of your net investment income or the amount your AGI exceeds the threshold. Net investment income is very broadly defined.  It includes interest, dividends, annuities, rents, royalties, any income from a passive business, and any capital gain.  Essentially it applies to all income not earned (via a job).  The tax does not apply to distributions from a qualified retirement account like a 401k or IRA.

In order to manage the new 3.8% Medicare Tax first depends on who exposed to the tax you are.  So first you must determine if your AGI is likely to exceed the threshold of $200,000.  Then you must evaluate how much “net investment income” you have.

Evaluating Potential Exposure

Below are several examples of women who may have exposure to the new 3.8% Medicare Tax….

Sally — Sally has net investment income of $75,000 plus $100,000 of other income (social security, pensions, etc) for a total AGI of $175,000.  She is below the basic threshold of $200,000 for the 3.8% Medicare Tax to apply to her and therefore she will not owe anything under the 3.8% Medicare Tax.

Evelyn –  Evelyn has net investment income of $50,000 plus $250,000 of other income for a total AGI of $300,000.  Thus she has $100,000 of in excess of the threshold amount.  Since the 3.8% Medicare Tax is owed on the lesser of net investment income ($50,000) or the excess of AGI over the $200,000 threshold she will owe tax.  Specifically she will owe $1,900 ($50,000 x 3.8%).

Rachel — Rachel has net investment income of $200,000 plus $75,000 of other income for a total AGI of $275,000.  Her AGI exceeds the threshold by $75,000.  Since the 3.8% Medicare Tax only applies to the lesser of net investment income or the amount by which AGI exceeds the threshold, Rachel will pay the 3.8% Medicare Tax on only $75,000.

Margaret — Margaret has net investment income of $40,000 plus $175,000 of other income for a total AGI of $215,000.  Accordingly, the 3.8% Medicare Tax will apply to only $15,000 for the same reasons as Rachel.

Betty — Betty has net investment income of $0 and other income of $225,000 for a total AGI of $225,000.  In this case, although Betty’s AGI exceeds the threshold by $25,000 there will be no tax due because her net investment income is $0.  If there is no net investment income there’s nothing for the 3.8% Medicare Tax to apply towards.  In Betty’s case it is notable that her earned income exceeded $200,000 and she may still be subject to the new 0.9% Medicare tax on earned income per ObamaCare.

The examples above can be reduced to a relatively straightforward framework for evaluating whether or not you will be subject to the new 3.8% Medicare Tax.

1. Do you have AGI in excess of the threshold of $200,000 ($250,000 for joint returns)?  If not, there is no need to proceed further.
2. Do you have any net investment income?  If there is no net investment income there is nothing to which the tax can be applied toward.  No need to go any further.  If you do have net investment income, then…..
3. Determine the lesser of net investment income or the excess of AGI over the threshold.

What about my trust?

In the case of trusts (and estates) the 3.8% Medicare Tax on unearned income may also apply, subject to a similar, but slightly different, set of rules.  With trusts/estates the 3.8% Medicare Tax is assessed on the lesser of:

1. Undistributed net investment income; or
2. the excess of the trust/estate’s AGI over the threshold amount

The threshold amount for trusts/estates is dramatically lower ($11,650 as of 2012).  This means trusts/estates which retain income amy actually be at far greater exposure risk to the 3.8% Medicare Tax than individuals are.  As a small consolation, the threshold amount for trusts/estates is indexed annually for inflation.

The biggest difference for trusts/estates is that it only applies to undistributed net investment income.  Thus the income is retained by the trust versus paid out to a beneficiary.

The 3.8% Medicare Tax does not apply to tax-exempt trusts, charitable remainder trusts, and trusts created entirely for the benefit of public charities.  However, any distribution of net investment income from one of these trusts to an individual may still result in the 3.8% Medicare Tax being applied to the individual (i.e. in the case of a charitable remainder trust).

It is important to note the 3.8% Medicare Tax will not apply to grantor trusts because the trust’s income and deductions will be reported on the grantor’s tax return.  It will the grantor who must evaluate exposure to the 3.8% Medicare Tax for grantor trusts.

Impact of the 3.8% Medicare Tax

The most direct impact is the tax itself.  Notably this tax combines with whatever other taxes may apply to the income being taxed.  Thus capital gains taxes are subject to the applicable capital gains tax rate plus the 3.8% Medicare Tax.

3.8% Medicare Tax Crossover Zone

One problem that arises when planning for, and evaluating, the 3.8% Medicare Tax is so-called “crossover zone.”  The “crossover zone” applies when net investment income begins to push above the applicable threshold line.  This causes an increasing amount of investment income to be subject to the tax even if no further investment is earned.

For example, Susan has $150,000 of other income and $50,000 of net investment income.  Under the 3.8% Medicare Tax rules she will not owe any of the tax because her AGI would be right at the threshold of $200,000 as a single tax payer.  However, if Susan takes $20,000 in capital gains her AGI would be pushed to $220,000, her net investment income goes to $70,000 and $20,000 would be applied to the 3.8% Medicare Tax.

Let’s look at another example with Diane.  Diane, is a young working widow.  She earns a salary of $150,000 per year and has net investment income annually of $50,000.  At the end of the year she receives a $25,000 Christmas bonus at work.  She is now above the threshold and $25,000 will be applied to the 3.8% Medicare Tax in addition to the normal taxes she pays.

Reducing Your Exposure

To the extent that the 3.8% Medicare Tax only applies to “net investment income” above threshold levels here are some things you can do to reduce your “net investment income.”

1. Income from Municipal Bonds is not applicable toward net investment income.  If you are close the threshold you may want to consider shifting all, or part of, your fixed income allocation to municipal bonds.
2. Maximize deductions which lower AGI.  Here are some potential deductions which reduce AGI: educator expenses, health saving account (HSA) contributions, certain self-employment expenses, alimony paid, IRA contributions, and tuition.
3. Defer or accelerate income.  For example, if you know you aren’t going to have as much other income next year it may make sense to delay a capital gain so as to keep yourself under the threshold.  Alternatively, if you know your other income or net investment income is going to be high next year try to take more income this year.
4. Rental real estate investments are wonderful investments for the 3.8% Medicare Tax as the the 3.8% Medicare Tax only applies to the “net” income and not the “gross” income.  Most real estate investments take advantage of depreciation to lower their net income and therefore reduce exposure to the 3.8% Medicare Tax in doing so.  …watch out for the capital gains and depreciation recapture on the sale of the property though.
5. Convert investments into conduits which aren’t subject to the 3.8% Medicare Tax.  Investment vehicles like IRAs, Roth IRAs, 529 plans, Health Savings Accounts, and Coverdell Educational Savings Accounts (aka Educational IRA).  Non-qualified deferred compensation may also be appealing.
6. It starts to become worthwhile to explore the benefits of making non-deductible contributions to a Traditional IRA.  Ordinary income tax is due on the growth of the IRA when distributed but the 3.8% Medicare Tax is permanently avoided.  There are a few complications with non-deductible contributions to an IRA so work with your advisor closely on this strategy.  ….it is important to note this same strategy does not work with an annuity.  Distributions from annuities still falls into the 3.8% Medicare Tax.  So be careful when opting to use an non-qualified annuity to try to avoid the 3.8% Medicare Tax.
7. Use a life insurance policy.  For starters, growth in a life-insurance policy is tax deferred.  When it comes time to extract money from a life insurance policy money is first distributed from contributions which is not subject to tax.  When distributions start to exceed contributions many people will then opt to take a loan against the policy which can help them avoid tax.  The caveat is that the policy must remain in force until death; if the policy ever lapses gains must be recognized and the 3.8% Medicare Tax may apply.  It is not recommended that a life insurance policy be used to avoid the 3.8% Medicare Tax …the tax is only 3.8% so there must be other reasons to purchase a life insurance policy.

Words of Caution

At the end of the day the tax is only 3.8%.  On a $100,000 investment earning $8,000 in income the tax would only be $304 (a net impact of 0.304%).  Changing investments that reduce expected return by more than 0.304% can result in less wealth than just paying the tax.  This is extremely relevant in the context of annuities, life insurance and mutual funds due to internal expenses of the products.

Also, shifting income can unintentionally cause you to bump up a tax bracket.  To avoid a 3.8% tax it doesn’t make sense to move up a tax bracket.  For example, a large Roth IRA conversion might help avoid the 3.8% Medicare Tax in the future by reducing future AGI in retirement years but if the conversion shifts your income into the 35% tax bracket when you are normally in the 28% bracket the loss on the potential returns of the current tax paid negates the savings from simply avoiding a 3.8% tax.

Conclusion

Widows must be especially cognizant of the new 3.8% Medicare Tax.  There threshold for the 3.8% Medicare Tax is the same as a single taxpayer ($200,000 currently) and thus become subject to the tax quicker than a married couple.  It makes sense to work with your wealth management team so you understand your potential implications under the new 3.8% Medicare Tax laws.