By Adam Cmejla, CMFC
SYNOPSIS
Proven strategies can minimize your exposure to a new 3.8 percent tax. Saving money requires that you act early.
ACTION POINTS
KNOW WHO OWES THE TAX. Those potentially affected include single tax filers whose adjusted gross income is over $200,000 and most married doctors filing jointly (MFJ) with annual gross income (AGI) above $250,000.
KNOW WHEN YOU’RE EXEMPT. Among other exemptions, S-Corp practices that own real estate may be exempt.
ASSET LOCATION MATTERS. Roth IRA’s and 401(k)’s, municipal bonds and other considerations can help you avoid the tax, both now and later in retirement. Roth IRA distributions in retirement are not counted towards AGI or MAGI, thus allowing you to potentially keep your income under the tax’s threshold amounts.
There is a new 3.8 percent tax potentially affecting all ODs. However, there are actions you can take before Dec. 31, 2014, to minimize your exposure to this tax.
On January 1, 2013, a new 3.8 percent tax on certain kinds of investment income became law, which stemmed from part of the legislation that created the Affordable Care Act (ACA). The Medicare surtax (officially termed the Unearned Income Medicare Contribution) affects those single tax filers whose adjusted gross income is over $200,000 and most married doctors filing jointly (MFJ) with annual gross income (AGI) above $250,000. As a financial adviser, who works regularly with optometrists, and is a spouse of an OD-practice owner, I know first-hand how important it is to fully understand new taxes. Here are the key points to remember about the new Medicare surtax.
Who will owe the tax?
The tax is also referred to as the NIIT (Net Investment Income Tax) and will be levied on the lesser of two amounts: either (a) your net investment income or (b) your modified adjusted gross income (MAGI) in excess of either the $200,000 or $250,000 threshold, depending on your filing status. Should either (a) or (b) be zero, the tax won’t apply to you.
Net Investment Income Tax
Click HERE for the IRS’s guide to the Net Investment Income Tax.
How do we define “Net Investment Income (NII)?
Net investment income is defined as interest, dividends, annuities, rents, royalties, income derived from a passive activity, and net capital gain derived from the disposition of property (other than property held in an active trade or business), reduced by deductions properly allocable to such income.
It does not include salary (W-2), wages, or bonuses, distributions from IRA’s or qualified plans (though distributions from IRA’s and QP’s do count towards AGI; more on this later), any income taken into account for self-employment tax purposed, gain on the sale of an active interest in a partnership or S-corporation, or items which are otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt bonds, capital gain excluded under IRC 121 and veteran’s benefits.
How the Medicare Surtax Plays Out: Three Examples
Example #1: Dr. Smith and his wife Nancy file a joint tax return. They have $400,000 in salaries (W-2) and $75,000 of net investment income. They will pay the 3.8 percent NII tax on the $75,000 of investment income (tax is levied on investment income if above the MFJ threshold of $250,000). Because the threshold applies to MAGI, not just the investment income, they are over the threshold and will be taxed on the lesser of net investment income or the amount of income that is above the threshold. Since their income only comes from two places (salary and investment income), the tax applies to their investment income of $75,000 since it is the lesser of the two.
Example #2: Drs. John and Mary file a joint return and have W-2 salaries of $300,000 and no investment income. They will not pay any additional tax because they have no investment income (W-2 wages do not count toward the tax).
Example #3: Dr. Linda is single, has a $100,000 salary and $75,000 of net investment income for MAGI of $175,000. The 3.8 percent tax would not apply because her MAGI is less than $200,000.
Commonly Asked Questions
My practice is set up as an S-Corp, but I own the land that the practice sits on. Will I owe the tax?
Originally, you would have, which would have made for some interesting planning for advisors and CPA’s. However, the IRS came out with revised rules and interpretations for this tax in November, 2013. The IRS clarified that “self-rental income,” or income that comes from a taxpayer owning a building and renting it to a pass-through entity in which the taxpayer materially participates. In this case, the optometrist “materially participating” in the practice and personally owning the land would be exempt from owing the 3.8 percent tax on net investment income that he realized from rental payments from his practice to himself.
In the past, I was looking to diversify my portfolio and started investing in real estate. Will my rental income that I generate now make me subject to the tax?
Unfortunately, yes it will. Your net rental income is subject to the tax unless you qualify for the real estate professional exemption. Your net rental income consists of your gross (total) rents minus all deductible expenses for your rentals. Your deductible expenses for these purposes will generally be the same as they are shown on your Schedule E of your tax return. For example, if you have $150,000 in gross receivable rent collected and expenses of $70,000, you’ll have net investment income of $80,000 that will flow through to your adjusted gross income and be figured into the equation to determine whether or not you’ll owe the extra tax.
How do retirement plans factor into this planning piece?
While distributions from IRA’s and qualified retirement plans such as 401(k)’s, SEP IRA’s, SIMPLE’s, etc., are not subject to the tax, they do count toward your AGI and MAGI, so they are still something to consider, especially later on in retirement. If you have a large portion of your retirement nest egg in IRA’s and other plans that, when distributions are taken, will add significantly to your AGI, it may push you up above the threshold of $200,000 (S) or $250,000 (MFJ), thus making any NII you have subject to the tax.
What steps can we take today to reduce the tax, both now and later?
There are a number of steps that can be taken, and it’s important to understand that being proactive in planning is always going to be more cost-effective than reactive planning.
You may want to think about converting some of your IRA’s to Roth IRA’s. Roth IRA distributions in retirement are not counted towards AGI or MAGI, thus allowing you to potentially keep your income under the threshold amounts mentioned earlier. Systematically converting Traditional IRA’s to Roth IRA’s can be a very useful strategy.
You may also wish to think about changing the type of retirement plan that you have in your practice.
If you’ve been getting by with a SIMPLE IRA, SEP, or basic 401(k), it may be time to start evaluating whether introducing a better-structured 401(k) with a Roth provision makes sense for your practice. Again, Roth IRA/Roth 401(k) distributions in retirement do not count towards MAGI/AGI. If you are not currently maxing out your retirement plan contributions, now’s the time to start.
It is also prudent to consider municipal bond investments in your taxable investment accounts as municipal bond interest is exempt from being included in your MAGI calculation.
Those who are subject to the tax may also wish to look at outright gifts to children, LLC’s and partnership’s, as well as possibly harvesting losses on past investments to reduce the overall NII tax.
All of these strategies should be discussed and talked through thoroughly with your CPA and/or tax advisors, as well as your financial advisor. A good financial advisor will know how to “quarterback” these situations and determine, based on your financial positions, which strategies are going to be most prudent and best suited for you given your goals and intentions.
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Adam Cmejla, CMFC, based in Carmel, Ind.,is president of Integrated Planning & Wealth Management, LLC, a financial planning and investment management firm “focused on working with optometrists to help them achieve their true financial potential, build financial confidence and clarity, and delivering kindness and compassion to every relationship they’re privileged to serve.” To contact: 317-853-6777 or adam@integratedpwm.com.
