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Tax Note: The Affordable Care Act and your Finances

by David Van Meter, M.S.Acc., Ph.D.


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The "Affordable Health Care Act", or "Obamacare" as some people prefer to call it, has been law since March 23, 2010, although its provisions are being enacted in a graduated manner between the date of the bill's passage and 2020. However, some major provisions for funding the "Affordable Health Care Act" have already taken effect, and these changes to our tax laws may have a significant impact on your income taxes. Now is the time to take stock of the new situation, and see if some tax planning may be helpful to your overall financial picture. In this article, we will introduce you to the new 10% floor for medical expense deductions, and the new Medicare surtax on earned income and net investment income.

The Medical Expense Deduction

The first major change to our tax laws that we would like to discuss is also the easiest to understand. Starting in 2013, the floor for deductible medical expenses has risen from 7.5% of your Adjusted Gross Income (AGI) to 10% of your AGI. This is a potentially big change, since in the past if you had an AGI of $50,000, you could deduct any medical expenses that exceeded 7.5% of that, or $3,750. Starting this year, however, you can deduct only those expenses that exceed 10% of that AGI, or $5,000. Effectively, if you have a lot of medical bills AND you itemize your deductions, you may have lost a deduction that is equivalent to 2.5% of your AGI.

How can we minimize the impact of this increase to the medical expense deduction floor? First, if you are already age 65 years or older, you (and your spouse) have a three year exemption to the new 10% medical expense deduction floor. If you are under age 65, then you may wish to consider planning ahead for certain medical expenses for which you control the timing of payments, and strive to bunch as many of these payments as possible into a single year, in order to maximize the amount of the medical expenses above the new and higher floor. For example, if you are considering orthodontics for your child, it may make financial sense to pay the orthodontist all at once rather than scheduling payments over several years.

The Medicare Surtax - Earned Income

Since 2013, so-called wealthy people, which the "Affordable Health Care Act" defines as couples with incomes over $250,000 and single people with incomes over $200,000, are now subject to a Medicare surtax that will help pay for the "Affordable Health Care Act". The first aspect of this surtax is fairly straight forward: if your earned income (i.e., wages, bonuses, self-employment income) is over $250,000 for a married couple or $200,000 for a single person, that amount over the threshold will be subject to an additional Medicare surtax of 0.9% in addition to the 1.45% that you are currently paying on such income, and the 1.45% that your employer is paying. If you are self-employed, then the new 0.9% surtax is of course in addition to the 2.9% that you are currently paying. Thus, in total, your new Medicare surtax is 3.8% on all earned income over your threshold ($250,000 married, $200,000 single).

If you have W-2 income, your employer is required to withhold this amount, and you may already have noticed the extra deduction from your pay. However, if you are married and neither you nor your spouse earn over $250,000, but combined your salaries exceed that amount, then your employers will not withhold the appropriate 0.9% surtax for you, and you will have to pay the amount at tax time. You can file a w-4 with your employers to increase your withholding, however.

The Medicare Surtax - Net Investment Income

The second aspect of the Medicare surtax that we need to discuss concerns the surtax on net investment income, and it is a bit more complicated. In the past, investment income was generally not subject to either Social Security taxes or to Medicare taxes. Now, if your Modified Adjusted Gross Income (MAGI) is over $250,000 for married couple or $200,000 for single people, then a portion of your net investment income may be subject to the entire 3.8% Medicare surtax for so-called wealthy people.

What is net investment income? According to the new provision in the tax code (USC 26, Section 1411), investment income includes interest (to include your bank interest), dividends, annuities, and net capital gains (to include capital gains on second homes and real estate investments). Net investment income ALSO includes net rental income (such as from apartments you own), royalties, and certain passive income. In other words, given the broad definition of investment income, if you are so-called wealthy American under the terms of the law, you may find a disturbingly large swath of your income may be subjected to the 3.8% Medicare surtax!

Net investment income does not include tax-exempt interest from municipal bonds, withdrawals from a retirement plan such as a traditional IRA, Roth IRA, or 401(k), and payouts from traditional defined-benefit pension plans or annuities that are part of retirement plans. Also exempt are life-insurance proceeds, veterans' benefits, Social Security benefits, and income from businesses in which you actively participate, such as S-corporations or partnerships.

How does the new Medicare surtax on net investment income work? The rule of thumb is pretty simple: you will pay the 3.8% surtax on the lesser of your net investment income, or the amount that your MAGI exceeds your threshold (again, $250,000 for married couples and $200,000 for single people). Your MAGI consists of your earned income, your taxable net investment income, and all other taxable income such as IRA distributions or 401)k) distributions. Thus, while IRA or 401(k) distributions are not themselves subject to the 3.8% Medicare surtax, they could conceivably push your MAGI up to the point that the sum total of your distributions plus your earned income plus your investment income exceeds your threshold!

Let's look at an example. Paula's MAGI is $230,000, of which $220,000 is wages and $10,000 net investment income. Her MAGI is $30,000 over the $200,000 threshold for individuals. She'll owe the 3.8% Medicare tax on her $10,000 of net investment income, because it is less than the amount she is over the MAGI threshold ($30,000). Paula will also owe 0.9% on the $20,000 she is over the $200,000 earned income threshold for individuals. So Paula's Medicare surtax will be $560, which includes $380 (3.8% of $10,000) and $180 (0.9% of $20,000).

Trusts and estates are also impacted by the Medicare surtax. For trusts and estates, the calculation of the 3.8% Medicare Surtax is also dependent on two figures: the undistributed net investment income (UNII) and the adjusted gross income. Similar to the calculation for individuals, the AGI for the taxable year is first reduced by a fixed threshold amount, and then compared to UNII. The lessor of the two is multiplied by 3.8% to determine the 3.8% Medicare Surtax for that taxable year. Unlike the calculation for individuals, however, the threshold is adjusted each year based on the dollar amount that starts the highest tax bracket. For the fiscal year of 2013, that amount is about $12,000.

Tax Planning

If you are still working, reducing your MAGI can be difficult to the extent that you draw a salary. One possible strategy would be to maximize all of your before-tax payroll deductions, and especially your 401(k) or 403(b).

The more complicated planning challenges come arise when considering the net investment income portion of the new tax. As always, upur financial advisor may be able to help you prepare and carefully execute a well-designed investment and tax plan, and there may be ways you can potentially reduce net investment income and, thus, the potential impact of this new tax.

One possible strategy - and it is certainly not appropriate for everyone! - would be to shift some of your investments with taxable earnings into municipal bonds and municipal bond funds, which generate interest that is non-taxable and thus excluded from the MAGI and the net investment income calculation. Municipal bonds may also provide another potential benefit of not triggering the Medicare surtax on other investment income. Alternatively, for some investors investments that produce taxable interest or that pay dividends could be held in a tax-deferred account like an IRA or possibly a tax-deferred annuity. You may also consider owning a form of permanent life insurance, since the cash value of these polices when withdrawn is not considered net investment income.

All in all, a tax-smart investment plan is more important than ever. Meet with your your financial advisor to ensure that your tax planning matches your investment and income needs!

Photo credit: Chris Potter @ Flickr

Van Meter and Van Meter, LLC.
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