Through the end of this year, the so-called Bush tax cuts are cast in stone, and investment income will be taxed at relatively favorable rates. But next year could be a much different story. That's because the various tax cuts will automatically expire at year end unless Congress takes action.

In addition, a new 3.8 percent Medicare surtax on investment income earned by higher-income individuals is scheduled to take effect next year. The new surtax is part of the 2010 healthcare legislation that was recently upheld by the Supreme Court.

For more information about the changes in the estate tax scheduled for next year, clickhere to read our previous article.

 Year

Highest bracket 
tax rate

1993-2000

39.6%

2001

39.1%

2002

38.6%

2003-2012

35%

 

39.6% 
unless Congress acts

The combined tax impact of the expiration of the Bush tax cuts and the 3.8 percent Medicare surtax has been dubbed "Taxmageddon" for higher-income investors. Here's what you need to know to be prepared.

Impact of Expiring Investment Tax Cuts  

For 2013 and beyond, the maximum federal income tax rate on most long-term capital gains is scheduled to rise to 20 percent (up from the current 15 percent). However, an 18 percent maximum rate will apply to most long-term gains from selling investments that were acquired after December 31, 2000 and held for more than five years.

Starting next year, dividends will once again be treated as ordinary income and taxed at regular rates -- as was the case before the Bush tax cuts. This is really bad news because the maximum federal rate on ordinary income, including dividends, for 2013 and beyond is scheduled to be 39.6 percent. For 2012, qualified dividends are taxed at a maximum rate of only 15 percent. 

For 2013 and beyond, the top federal rate on short-term capital gains, taxable interest income, rental income, royalties, and income from annuities will increase to 39.6 percent because these types of investment income are taxed at ordinary rates. For 2012, the maximum rate on ordinary income is 35 percent.  

Starting next year, the phase-out rules for personal and dependent exemption deductions and itemized deductions are scheduled to return with full force. These disguised tax increases can reduce or even eliminate exemption deductions and wipe out up to 80 percent of certain itemized deductions -- including the ones for home mortgage interest, state and local income and property taxes, and charitable donations. For higher-income investors, these deduction phase-out rules can make your federal income tax bill just that much higher.

Impact of the New 3.8 Percent Medicare Surtax

Starting next year, higher-income individuals may also be hit with a new 3.8 percent Medicare surtax on all or part of their net investment income. For purposes of this surtax, net investment income is calculated in two steps.

Step 1: Add up the following:

    • Gain from selling assets held for investment -- including gain from selling investment real estate and the taxable portion of gain from selling a personal residence. 

      Note: Gain from selling a principal residence is federal-income-tax-free to the extent of the allowable home sale gain exclusion (up to $250,000 for an unmarried taxpayer and up to $500,000 for a married joint-filing couple). Such tax-free principal residence gains are exempt from the surtax. However, to the extent a principal residence gain exceeds the exclusion, the excess is potentially subject to the surtax. Gain from selling a vacation property is also potentially subject to the surtax.
  • Gross income from dividends.
  • Gross income from interest (not including tax-free interest such as municipal bond interest).
  • Gross income from rental activities.
  • Gross income from royalties.
  • Gross income from annuities.
  • Gross income and gains from passive business activities (as opposed to business activities in which you actively participate) and gross income and gains from the business of trading in financial instruments or commodities (whether you actively participate or not).

Step 2: Reduce the total from Step 1 by deductions properly allocable to the types of income listed in Step 1. The result is your net investment income amount.

Gains and Income from Businesses: In general, gains from selling assets used in a business in which you actively participate are apparently outside the definition of net investment income and are therefore exempt from the Medicare surtax. (As indicated above, an unfavorable exception to the preceding general rule applies to gains from the business of trading in financial instruments or commodities. Such gains are included in the definition of net investment income--whether you actively participate or not--and are therefore potentially subject to the surtax.)

Income from dividends, interest, rents, royalties, and annuities earned in the ordinary course of a business in which you actively participate are also apparently outside the definition of net investment income and are therefore exempt from the surtax.

However, gains and income attributable to a passive business activity such as rental real estate or a partnership or S corporation in which you do not actively participate are potentially subject to the surtax.

Retirement Plan Distributions: Distributions from tax-favored retirement plans and accounts such as 401(k) plans, pension plans, traditional IRAs, and Roth IRAs are exempt from the surtax. Social Security benefits are also exempt.

Income Threshold and Tax Base: You will not be hit with the 3.8 percent Medicare surtax on net investment income unless your modified adjusted gross income (MAGI) exceeds:

  • $200,000 if you are unmarried.
  • $250,000 if you are a married joint filer.
  • $125,000 if you are married, and you and your spouse file separately.

The amount subject to the 3.8 percent Medicare surtax is the lesser of:

  • Your net investment income or
  • The amount by which your MAGI exceeds the applicable threshold. For this purpose, MAGI is defined as regular AGI from the bottom of page 1 of your Form 1040 plus certain tax-free income from foreign sources (relatively few taxpayers have such income).
Example 1: In 2013, you and your spouse file jointly. You have $310,000 of MAGI that includes $90,000 of net investment income. You will owe the 3.8 percent Medicare surtax on $60,000 (the lesser of your excess MAGI of $60,000 or your net investment income of $90,000).  

Example 2: In 2013, you file as an unmarried individual. You have $310,000 of MAGI, which includes $90,000 of net investment income. You will owe the 3.8 percent Medicare surtax on $90,000 (the lesser of your excess MAGI of $110,000 or your net investment income of $90,000).

Example 3: In 2013, you and your spouse file jointly. You have $240,000 of MAGI. You are exempt from the 3.8% Medicare surtax because your MAGI is below the $250,000 threshold for joint filers. Therefore, it doesn't matter how much of your income is from investments.

Example 4: In 2013, you file as an unmarried individual. You have $190,000 of MAGI. You are exempt from the 3.8 percent Medicare surtax because your MAGI is below the $200,000 threshold for singles. Therefore, it doesn't matter how much of your income is from investments.

Trusts: Trusts can also be hit with the 3.8 percent Medicare surtax. The surtax will apply to thelesser of:

  • The trust's undistributed net investment income or
  • The trust's AGI in excess of the threshold for the top trust federal income tax bracket. For 2013, that threshold is expected be around $12,000. As you can see, many trusts could be affected.

Impact on Maximum Federal Rates on Investment Income

Unless something changes, the demise of the Bush tax cuts in conjunction with the 3.8 percent Medicare surtax will result in the following maximum federal rates on investment gains and income recognized by individuals and trusts in 2013 and beyond.

  • 23.8 percent (20 percent plus 3.8 percent) on long-term capital gains (versus 15 percent for 2012).
  • 43.4 percent (39.6 percent plus 3.8 percent) on short-term capital gains (versus 35 percent for 2012).
  • 43.4 percent (39.6 percent plus 3.8 percent) on income from dividends, interest, rental activities, royalties, and annuities (versus 15 percent on qualified dividends for 2012 and 35 percent on these other types of income for 2012).
  • 43.4 percent (39.6 percent plus 3.8 percent) on ordinary income from passive business activities and ordinary income from the business of trading in financial instruments or commodities (versus 35 percent for 2012).

Tax Planning Considerations

If you think you will be affected by these tax rate increases on investment income for 2013 and beyond, you may want to take some steps this year to decrease your exposure. For instance, investment gains that are recognized this year instead of next year will be taxed at today's favorable rates. However, triggering gains this year will generally result in an accelerated tax bill. If you have 2012 capital losses or a capital loss carryover from before this year, things get more complicated (these losses can potentially be used to shelter capital gains recognized this year or capital gains recognized in future years when tax rates are scheduled to be higher).

Finally, depending on how the November 6th election turns out, it's possible that none of the aforementioned tax increases will take effect. However, the prudent approach is to:

  • Plan for the worst while hoping for the best and
  • Be prepared to make some tax planning moves after the November election results are known, but before year end. Contact your adviser for assistance in determining the best action plan for your specific circumstances.

Disclaimer: There are many unanswered questions about exactly how the new 3.8 percent Medicare surtax on net investment income will work. The information in this article is general in nature and based on what we think are reasonable interpretations of the statutory language and legislative history. Some of what we say here could be contradicted by future IRS guidance.

© Bizactions LLC.