For tax years beginning after 2012, in addition to the expiration of the 2001 Bush tax cuts, higher income taxpayers will incur additional taxes as a result of the revenue raising provisions included in the 2010 Health-Care Reform tax laws. Although it’s difficult to predict whether or not we’ll actually see these tax increases, given the state of our federal, state, & local governments, it would be prudent for taxpayers to hope for the best, but prepare for the worst. Below are the highlights of the tax changes scheduled to take effect in 2013.

Medicare tax increase – Starting in 2013, Medicare tax will be increased .9% for compensation exceeding $250,000 if you are married filing a joint return ($200,000 for single taxpayers and $125,000 for married filing separate taxpayers). Employees will have the additional tax withheld from their wages.

Self-employed individuals will pay the additional Medicare tax on the self-employment income that is over the above dollar amounts. While self-employed individuals are allowed to deduct ½ of their self-employment tax to arrive at their adjusted gross income, the additional Medicare tax will not be included in that deduction.

Medicare tax on unearned income – Starting in 2013, a 3.8% Medicare tax is imposed on unearned income with Adjusted Gross Income (AGI) over $250,000 if married and filing a joint return ($200,000 for single taxpayers and $125,000 for married filing separate taxpayers). Note: Estates and trusts are also subject to the unearned income Medicare tax.

Unearned income includes interest, dividends, annuities, royalties, capital gains, and passive real estate rental income or other passive activities. It does not include tax-exempt bond interest, veteran’s benefits, qualified retirement plan (ex. 401k distributions), and IRA distributions.

The tax is imposed on a) an individual’s net investment income, or b) the excess of the above thresholds of your modified adjusted gross income, whichever is less. Below is an example of how this tax will be calculated:

Example 1: John & Jane, a married couple filing a joint return and have a modified AGI of $350,000 in 2013. Of that amount, $80,000 is investment income. The excess of the modified AGI over the $250,000 threshold is $100,000. So John & Jane will pay 3.8% on $80,000 (the lesser of the two) or $3,040.

Example 2: Assume the same facts as the above example, except that the modified AGI includes $125,000 in investment income. John & Jane will pay 3.8% on $100,000 (or $3,800) since the excess of the modified AGI ($100,000) is less than the investment income ($125,000).

Itemized medical expenses – Starting in 2013, only medical expenses that exceed 10% of the AGI (7.5% prior to 2013) will be deductible. The current 7.5% limit will continue to apply to taxpayers 65 and over.

Many are waiting until after the presidential election to make a move. However, if these new tax laws affect you, it’s important to think about ways you can reduce your investment income and modified adjusted gross income. Consider a few strategies that may be attractive to some taxpayers:

  1. Tax-exempt bonds may now be more appealing since the interest is not included in investment income
  2. Consider selling assets in 2012 instead of 2013 or 2014
  3. Installment sales may make more sense in some situations
  4. Since IRA distributions will be used in calculating modified AGI, Roth conversions in 2012 may be an option for reducing AGI in future tax years
  5. Insurance and deferred annuities, charitable lead trusts, and charitable remainder trust may have more merit

For additional information regarding these tax changes or to schedule a consultation, please contact Heintzelman Accounting Services, Inc.