Devising strategies for the 3.8% Medicare surtax

It is two months into 2013, but tax gurus say that it isn’t too late to prepare clients’ portfolios for the Medicare surtax that will take a bite out of their investment income.

This year heralded the arrival of the new tax, a levy of 3.8% on earnings from nonqualified annuities, dividends, rents and taxable interest. It is the insult topping off the injury for the highest earners, who face a marginal income tax rate of 39.6% this year.

“[Last year] was the opportune time to get in front of it, but now that the tax is in place, it’s about controlling the net investment income you produce,” said Gavin Morrissey, vice president of wealth management at Commonwealth Financial Network.

In fact, there are a range of strategies for those in and nearing retirement, including evaluating bond holdings, considering charitable trusts and establishing other tax-deferred growth vehicles, such as defined-benefit pension plans for small-business owners.

As always, the biggest caveat in planning for the Medicare surtax is that each solution needs to be tailored to the individual client. The tax will be levied on the lesser of either net investment income — income coming from interest, net capital gains and dividends — or excess amounts of modified adjusted growth income above $200,000 a year for individuals or $250,000 for couples.

HIGH-EARNING RETIREES

That said, the fact that the tax will hit income from interest means that many high-earning retirees can expect to feel the effects, particularly as interest rates rise on bond investments.

“The real issue is going to be for a lot of people who aren’t subject to the tax now because [interest] rates are so low,” said Martin M. Shenkman, a tax attorney at an eponymous firm. “But if rates rise, more people will be subject to it than you realize.”

Income from bond holdings has been artificially reduced by low interest rates, but that income will rise when rates go up, Mr. Shenkman said.

Investors might want to rethink their bond holdings, perhaps replacing corporate bonds with tax-free municipal bonds, the interest on which doesn’t count toward the net investment income or MAGI calculations.

Interest generated from corporates, however, counts toward those numbers, said Susan Hartman, a wealth strategist at Raymond James Financial Inc.

Stock holdings also deserve a second look.

“Clients in their spend-down years might have excess income generated in their portfolio. Instead of buying bonds that kick out interest income or stocks that produce dividends, buy some capital appreciation stock,” Ms. Hartman said.

“Master limited partnerships for a small part of a portfolio might make sense, also tax exempt bonds, annuities and life insurance,” said Robert S. Keebler, a partner at Keebler & Associates LLP. “This [surtax] is a long-term issue, and there’s no silver bullet for this.”

CHARITABLE TRUSTS

Meanwhile, charitable trusts can come in handy for clients who own a large asset that has appreciated and will be liquidated.

The asset, such as a business interest, can be sold, and capital gains and income taxes can be spread out over time.

Certain charitable lead trusts aren’t subject to the 3.8% surtax, either, Ms. Hartman said.

This particular strategy is more popular when capital markets are faring well, which is when clients are thinking about liquidations, Mr. Morrissey said.

Investors who are still working will want to maximize their tax-deferred retirement savings, at least with the hope that the 3.8% surtax will have been rolled back or repealed by the time that they decide to stop working.

Small-business owners, however, have another weapon in their arsenal: opening a defined-benefit plan so that they can save beyond the $17,500 annual limit for 401(k) contributions.

ROTH CONVERSIONS

“If I put in a defined-benefit plan and that allows me to quadruple what I’m putting in, wouldn’t it make sense to incur the expense for the rank and file so that I can get that benefit for myself and my spouse?” Ms. Hartman asked. “The salary I defer into the plan is now pulled out of the 3.8% tax environment, as long as it stays in the plan, and hopefully, when I retire, there’s no more 3.8% surtax.”

Finally, given the income threshold clients must meet to be subject to the Medicare surtax, advisers may want to think about tax diversification via Roth conversions so that retirees can tweak their income withdrawal strategies and make them tax-efficient.

This way, clients can control their tax brackets, Mr. Morrissey said.

However, clients considering a Roth IRA conversion this year need to ensure that the amount they convert — which will be included in their MAGI — doesn’t trigger the 3.8% surtax.

“As far as strategies go, if you’re in a lower marginal-income-tax bracket in a given year, it’s a good idea to convert,” Mr. Morrissey said.

If clients run the risk of hitting the threshold, they will have to work with their accountant to determine how much leeway they have to make a Roth conversion without triggering the tax.

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