Advisers and clients might want to take a closer look at the tactics they're using to mitigate the new 3.8% investment income tax because certain strategies could lead to higher Medicare premiums.
The 3.8% surtax, which kicked in at the start of this year, is a levy on net investment income — income from nonqualified annuities, rents and taxable interest — for individuals, estates and trusts. Individuals owe the tax if they have net investment income and at least $200,000 in modified adjusted gross income (filing as a single person) or $250,000 if filing jointly. When the tax is levied, it's based either on the net investment income or the amount by which the taxpayer's modified adjusted gross income exceeds the threshold, whichever is less.
There is also a second “additional Medicare tax” of 0.9% that applies to wages that are over the thresholds.
Though advisers and accountants have spent a good part of the year bringing the issue to clients' attention and devising strategies to cope with the 3.8% surtax, some are now warning that plans that can reduce the impact of the tax may have unintended consequences: Namely, clients may end up inadvertently inflating their modified adjusted gross income when the time comes to apply for Medicare, leading to higher premiums.
“For that high-earning power couple in their late 40s and early 50s, Medicare isn't on the brain,” said Robert A. Klein, an adviser with Investors Capital Corp. “You're not thinking of Medicare, but the government has the last laugh: You're paying way more for Medicare.”
Individuals are supposed to sign up for Medicare three months before reaching 65. Everyone needs to sign up for Medicare, but Parts B and D — which cover doctors' visits and prescriptions, respectively, are subject to means testing based on an individual's latest federal tax return.
In most circumstances, the government will cover as much as 75% of premium costs, leaving the remainder to be covered by Medi-care beneficiaries. However, taxpayers with at least $170,000 in modified adjusted gross income when filing jointly — or $85,000 in MAGI if filing under any other status — will have to shell out anywhere from 35% to 80% of the total cost of Medicare Part B.
Medicare's MAGI calculation includes the adjusted gross income and tax-exempt interest income.
This throws a monkey wrench into clients' surtax planning because advisers may very well decide to turn to municipal bonds as an investment, since they would be exempt from the 3.8% surtax. The income stream they provide, however, will end up under consideration when the client's Medicare premiums are calculated.
Mr. Klein noted that there are a handful of investments that might mitigate that Medicare tax bite, including health savings accounts, cash-value life insurance and annuities that are optimally structured so that their payments are a combination of return of principal and interest.
“It's all about the sequence in how you take the money out,” Mr. Klein noted.
Roth conversions might also work to lower modified adjusted gross income if the client is willing to pay the taxes on higher income now, said J. Christopher Raulston, a wealth strategist at Raymond James Financial Inc.
He warned that surtax planning comes with its share of potential pitfalls and that it's important to ensure that tax planning strategies don't clash with other objectives.
“The problem is that when you're looking at surtax planning, it goes hand in hand but sometimes opposite with respect to income tax planning,” Mr. Raulston said. “You have to be careful about letting the tax tail wag the dog.”
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