As summer quickly passes and we head into the last half of 2013, it is a good time to evaluate your income and deductions for the year and begin working with your CPA on planning strategies to reduce your overall tax burden.
Specifically, upper income individuals should be aware of the additional Medicare Tax which applies to earned income (wages and self-employment income). Prior to this new tax provision beginning in 2013, any wages paid to you by your employer were subject to a 2.9% Medicare payroll tax, which was split equally by you and your employer (1.45% each). Beginning in 2013, wages above $200,000 for individual tax filers, or $250,000 for married taxpayers filing jointly, will be subject to an additional .9% Medicare tax.
For illustrative purposes, this would mean that if you and your spouse file a joint tax return and have combined wages of $350,000, you will end up paying an additional $900 in Medicare taxes. Employers are required to withhold this additional tax for employees with wages in excess of $200,000, and any underpaid or overpaid Medicare taxes will be adjusted for on your income tax return. Individuals with both wages and self-employment income aggregate their earned income in determining the additional Medicare Tax. For example, if a single taxpayer has $150,000 in wages and $150,000 in self-employment income, they would be subject to the additional tax on $100,000 of this earned income based on the $200,000 threshold for single filers.
In addition to the Medicare payroll tax increase, high income individuals also need to be conscious of the 3.8% Medicare tax on net investment income. This tax applies to the lesser of net investment income or modified adjusted gross income above $200,000 for single filers and $250,000 for joint filers. Net investment income includes interest, dividends, annuities, royalties and rents, and other income attributable to a passive activity. Capital gains, including any gain on the sale of your personal residence that is not excluded under Code Sec. 121, and gain from the sale of a vacation home or investment property, are also subject to this tax. For illustrative purposes, if married taxpayers have modified adjusted gross income of $400,000, which includes $50,000 dividend income (their only net investment income), they would be subject to the 3.8% increased tax on $50,000 of their income, in addition to ordinary income taxes at their marginal tax rates. Let’s assume that instead this married taxpayer had $270,000 of modified adjusted gross income. In this case, only $20,000 (the amount over the $250,000 threshold) would be subject to the additional 3.8% tax.
Trustees of irrevocable trusts should be familiar with how this 3.8% surtax effects trusts, as this increased tax not only applies to any net investment income that is taxable to an irrevocable trust, but also comes into play at a much lower threshold than with individual taxpayers. For an irrevocable trust, the 3.8% tax is imposed on the lesser of either undistributed net investment income or the excess of adjusted gross income over the highest trust tax bracket. For 2013, the highest trust tax bracket begins at $11,950, which means that trusts with undistributed net investment income over $11,950 are not only subject to the highest federal tax rate of 39.6%, but also the additional 3.8%, creating a combined overall tax rate of 43.4%. Ouch! When planning discretionary distributions to beneficiaries, trustees should be aware of these lower tax brackets and high tax rates as they may be able to relieve a significant tax burden by simply making distributions to beneficiaries in an irrevocable trust.
The good news is that there is still plenty of time in 2013 to plan for and reduce your exposure to these increased taxes. A few practical strategies include reducing your adjusted gross income by making larger contributions to pretax retirement plans, or considering an installment sale if you are planning on selling an investment property. To learn more about strategies to reduce your tax burden, contact your accountant at Linkeheimer CPA’s.
Written by Carli Ortiz, CPA, Manager LinkedIn Profile