High income earners will be subject to two new taxes starting in 2013 to help pay for health care reform, and they -- single people making more than $200,000 a year and couples filing jointly earning more than $250,000 -- need to get their heads around the rules so they can plan.
The first new tax is the Medicare surtax, which is surprisingly easy to calculate: Gross wages above the income thresholds are multiplied by 0.9%. The self-employed are subject to this tax as well.
The second tax is the Medicare Investment Income tax, calculated as the lesser of income over the $200,000 or $250,000 thresholds or unearned income. The lower of these two figures is multiplied by 3.8%. (The definition of "unearned income" is very broad. It includes interest, dividends, capital gains, annuities, royalties and rent. Excluded is tax-exempt interest and income from retirement accounts such as IRAs.)
I ran a 2013 federal income tax projection for a hypothetical high-income family in New Jersey with two children. I assumed wages of $1 million; rental income of $36,000; book royalties of $7,500; dividends and interest of $50,000; capital gains of $100,000; and investment income of $193,500.These two new taxes would create $14,103 of incremental taxes for the family. The Medicare surtax would be $6,750 -- that's $750,000 multiplied by 0.9% -- while the Medicare Investment Income tax would be $7,353, or $193,500 multiplied by 3.8%.
The only way to avoid the Medicare wage surtax is to earn less than the income thresholds. The Medicare Investment Income tax, though, can be mitigated with some planning.
One solution is to use tax-exempt municipals in your taxable portfolio. (Given the uncertainty surrounding many states' financial condition, single-state overconcentration should be avoided.) A second idea is to manage your capital gain recognition, possibly by investing in ETFs rather than mutual funds. With an ETF, typically you will recognize a capital gain only when you sell your shares, while with a mutual fund's structure you can have a taxable gain even if you don't sell your shares.