The Medicare Surtax It Has Implications for Doctors, Dentists, and Practice Managers

Starting Jan. 1, a new Medicare surtax of 3.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} will apply to unearned income of high-income individuals and trusts. With this tax increase and other potential tax changes looming, physicians, dentists, and practice administrators may want to carefully review their tax situation by the end of this year.

The political logjam in Congress during 2012 has once again left potential year-end tax-rate changes. Capital-gains tax rates, income tax rates, dividend tax rates, and estate taxes are all uncertain for 2013 and into the future. It is impossible to know at this time what action Congress will take to avoid all of the Bush-era tax cuts from expiring by the end of the year. This uncertainty has made a challenging environment for financial, estate, and tax planning.

While most tax rates in 2013 are uncertain, what is known is that provisions of the Patient Protection and Affordable Care Act of 2010 will impose a 3.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} surtax on individuals with modified adjusted gross income (MAGI) exceeding $200,000, or $250,000 for married couples filing joint returns. The 3.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} surtax applies to the lesser of net investment income ’NII’ or excess of ’modified AGI’ beyond the $200,000 or $250,000 thresholds.

’Modified AGI’ is AGI from the last line on page 1 of the 1040 return, plus certain other categories such as tax-free foreign-earned income and student-loan deductions. Net investment income includes interest, dividends, annuities, capital gains, royalties, and ’passive’ rental income. Tax-free interest income, payouts from retirement plans, active real estate, and active business pass-through income are excluded from net investment income.

With all of those definitions, it can be difficult to imagine exactly how the tax might apply in your particular situation. Remember that Congress’s goal was to tax unearned income for high-income individuals. Many physicians and dentists will fall into this category. If a doctor makes $400,000 per year but does not have investment income, the surtax will not apply. If a retired married couple files jointly and has $175,000 of net investment income and no other sources of income, the surtax does not apply. If a married couple filing jointly has a MAGI of $350,000 and $50,000 of net investment income, the surtax will apply to the $50,000 of net investment income.

For people who may be affected by the surtax, they may want to consider strategies to manage their income-threshold limits as well as their net investment income as part of their overall financial plan.

Taking capital gains in 2012 instead of 2013 is one way to reduce potential exposure to the 3.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} surtax. Without Congressional action, the normal capital-gain rate in 2013 will automatically increase to 20{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}. For top income earners, the effective capital-gain rate has the potential to change from the current 15{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} rate to 23.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} in 2013. That is potentially more than a 50{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} increase.

Individuals may want to consider converting some or all of their traditional IRA assets to a Roth IRA. In addition to potentially avoiding pushing up MAGI, converting assets today may reduce or eliminate future required minimum distributions (RMDs), minimizing future exposure to the surtax.

In 2013 and beyond, individuals can evaluate with their tax advisor whether to employ strategies to decrease their modified adjusted gross income to avoid the Medicare surtax. For example, maximizing retirement-plan contributions, shifting to tax-free municipal bonds, deferring income, and utilizing Roth distributions in retirement to meet cash-flow needs are all ways to reduce MAGI. It is also possible to reduce net investment income by using installment sales and reducing income from passive-activity investments, among other strategies. Of course, all of these strategies need to be consistent with your overall financial plan.

The Medicare surtax also applies to trusts and estates. For these entities, the 3.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} surtax is imposed on the lesser of the undistributed net investment income for the tax year, or the excess (if any) of the taxpayer’s adjusted gross income over the dollar amount at which the highest tax bracket begins ($11,650 in 2012). In practice, this means trusts will have an extra reason to distribute income to beneficiaries if the recipients are taxed at a lower tax rate than the trust.

Despite some calls for less complicated tax rules, the regulations are only getting more complicated. The Medicare surtax gives physicians and dentists an extra reason this year to do year-end tax planning. Potential actions (or inactions) by the lame-duck Congress following the November elections are another reason to be on alert.

Doug Wheat, CFP is director of Family Wealth Management in Holyoke; www.fwmgt.com