Health Care Surtax Goes Into Effect on January 1

Now that the health care law has been declared constitutional, one little known provision will go into effect on January 1, 2013.  This provision is a new 3.8% investment income surtax, also called the health care surtax or the Medicare tax.  The health care surtax will be assessed on the lesser of a) net investment income or b) the excess of modified adjusted gross income (MAGI) over the “threshold amount.”Net investment income is the sum of gross investment income over allocable investment expenses. For purposes of the health care surtax, investment income includes interest, dividends, capital gains, annuities, rents, royalties and passive activity income. It does not include active trade and/or business income; any of the income from interest, dividends, capital gains, etc. to the extent it is derived in active trade and/or business; distributions from IRAs and other qualified retirement plans; or any income taken into account for self-employment tax purposes. For the sale of an active interest in a partnership or S-corporation, gain is included as investment income only to the extent net gain that would be recognized if all of the partnership/S-corporation interests were at fair market value.The “threshold amount” varies.  For married taxpayers filing jointly it is $250,000.  For married taxpayers filing separately it is $125,000.  For all other individual taxpayers it is $200,000. For trusts and estates, it is the beginning of the top income tax bracket ($11,650 in 2012).The surtax liability is determined on income before any tax deductions are considered. That means your deductions could put you in the lowest income tax bracket, yet you could still have investment income that is subject to the surtax. Also, the capital gain rate is scheduled to increase for high-income taxpayers to 20% in 2013, so the total tax on capital gains (with the surtax) could be 23.8% in 2013 and beyond.Planning Considerations in 2012There are several steps you can take this year to help you reduce or avoid the amount of surtax beginning in 2013. These include shifting investments, converting to a Roth IRA, deferring income, increasing contributions to tax-deferred plans, installment sales and charitable trusts.2012 is also an exceptional year to do estate planning. The federal gift tax exemption is currently $5.12 million, which allows a married couple to remove as much as $10.24 million from their estate with no gift tax. Under current law, this exemption is scheduled to shrink to $1 million in 2013. Other Bush tax cuts, including income and capital gain taxes, are set to expire at the end of 2012. With the new 3.8% surtax becoming effective in January, 2013 is on track to have the highest tax rates we have seen in years.