Taxes on those with high incomes will go up next year, even though it's expected that by year-end, lawmakers will vote to extend all the Bush tax cuts through 2013. The raise will come from two Medicare surtaxes. The surtaxes were enacted in 2010 to help cover the cost of health care reform and they take effect next year. Congress is not expected to delay their implementation, although there is a chance they could be eliminated if the Supreme Court strikes down the entire health care law this Spring, but that isn't expected to happen.
The first surtax is a special 3.8% Medicare surtax on unearned income of single filers with Modified Adjusted Gross Income (AGI) over $200,000 and joint filers above $250,000. Modified AGI is AGI plus any excluded foreign earned income. The surtax is imposed on the smaller of the filer's net investment income or the excess of modified AGI over the thresholds. Investment income includes interest, dividends, capital gains, annuities, royalties, and passive rental income, but not tax free interest or payouts from retirement plans such as 401(k)s, IRAs, Roths, profit sharing plans, and defined benefit plans. So annuity payouts from retirement plans are exempt. A couple with $50,000 of investment income and AGI of $280,000 will pay $1,140 (3 .8%) on the $30,000 excess over $250,000. A single taxpayer with AGI of $400,000 and $50,000 of investment income will pay an additional $1,900 (3.8% of $50,000).
The surtax boosts the top rate on capital gains and dividends to 18.8% - the 15% nominal maximum rate that is expected to be in effect for 2013, plus 3 .8%. If you sell your primary residence, only the portion of the profit over the $250,000 or $500,000 exclusion will be subject to the tax if your AGI is high enough to trigger it. The full profit on sales of rental properties and second homes can be hit by the surtax. And note that the taxable gain may push your income over the surtax thresholds. So consider selling highly appreciated assets in 2012 instead of 2013.
Tax-exempt bonds will become more popular with high-income investors. Tax free interest is exempt from the 3.8% surtax and does not affect the owner's AGI. Deferring compensation beyond 2012 may end up triggering the surtax. Converting to a Roth this year instead of next may payoff. Although payouts from IRAs are exempt from the surtax, they are taxable and thus can boost your AGI, possibly triggering the surtax on your investment income after 2012. And the income from converting raises your adjusted gross income. Roth payouts are typically tax free.
The second surtax is a 0.9% surtax on earned income, which is wages and income from self-employment. Singles will owe the extra 0.9% Medicare tax once total earnings are more than $200,000. Couples will owe once total earnings are over $250,000. So the effective Medicare tax rate on earnings over the thresholds willbe 3.8% - the usual 2.9% rate plus an extra 0.9%. This is another reason you may not want to defer compensation into 2013.
If you have any questions or would like more information, please contact Fred Schutz at (856) 722-5300 ext. 201 or Dave Gill at ext. 210.
