I need article summary:Examining the Unearned IncomeMedicare Contribution Taxby James F. Ivers III, JD, LLM, ChFCAbstract: A new type of tax, named the gUnearnedIncome Medicare Contribution,h was enacted in 2010as part of health care reform legislation. It is an additionalincome tax on the unearned income of certaintaxpayers. This tax is different because it is essentiallyan extension of the Hospital Insurance tax, which is acomponent of existing FICA and SECA taxes onearned income. FICA and SECA taxes apply only toearned income, but the Medicare Contribution taxwill apply only to unearned income. Although it isnot scheduled to begin until 2013, taxpayers and advisorsshould have an understanding of its impendingconsequences before it actually goes into effect.JOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201139he health care reform legislation package signedby President Obama on March 23, 20101makes significant changes to the health caresystem in the United States. The legislation also containsseveral revenue-raising provisions designed to help offsetthe costs of government-supported health care programs.One of these provisions is the Unearned Income MedicareContribution2 tax. This article is an explanation of thenature and mechanics of this new kind of income tax thatis scheduled to take effect in 2013.Factors that create exposure to the tax will be examined,related tax law provisions that interact with it willbe described, and possible approaches to help avoid orminimize the tax will be suggested.Fundamentals of theMedicare Contribution TaxThe Unearned Income Medicare Contribution tax isa new type of income tax that will be imposed on certainunearned income of upper-income taxpayers at a fixedrate of 3.8% beginning in 2013. If applicable, it will bepayable in addition to the existing federal income tax.Summary of Existing FICA and SECA TaxesTo aid in the understanding of this tax, the existingtaxes on earned income designed for the funding of SocialSecurity and Medicare should be understood. Currently,there is a cumulative rate of tax equal to 15.3% imposedon earned income, including both wages of employeesand the net income of self-employed taxpayers. Thesetaxes are paid in addition to the federal income tax andwere enacted to fund Social Security and Medicare underThis issue of the Journal went to press in April 2011.Copyright c 2011 Society of Financial Service Professionals.All rights reserved.TExamining the Unearned Income Medicare Contribution Taxthe Federal Insurance Contribution Act (FICA) and theSelf-Employment Contributions Act (SECA). Foremployees, the payment of these taxes is subject to withholdingrequirements and is divided in half between theemployer and the employee. The employer pays 7.65% ofwages subject to the tax, and the employee pays the other7.65%. Each half includes 6.2% for the funding of SocialSecurity benefits (the OASDI or Old Age, Survivors, andDisability Insurance tax) and 1.45% designed for thefunding of Medicare (the HI or Hospital Insurance tax).The portion that is designed to fund Social Security isimposed only on covered wages or self-employment incomeup to the amount of the Social Security wage base for agiven tax year ($106,800 for 2011). On the other hand, thetax for the funding of Medicare is paid on all such incomeregardless of the amount. Therefore, out of the total of15.3%, 12.4% is paid on income up to the Social Securitywage base and 2.9% is paid on all levels of earned income.Self-employed taxpayers are responsible for payingthe entire 15.3% tax to fund Social Security andMedicare. An above-the-line federal income tax deductionfor one-half of these taxes is available to the selfemployedto reduce their net cost.3 The deductible halfrepresents what would be the employerfs portion of thesetaxes if the taxpayer were an employee.For 2013, when the new Medicare Contribution tax isscheduled to begin, there is also a scheduled increase in therate of Hospital Insurance tax on earned income abovespecified levels based upon filing status.4 This increase willadd .9% to the existing 2.9% tax designed to fundMedicare, raising the total potential tax to 3.8% of the portionof earned income to which it applies. Specific rulesapplicable to this .9% increase will be discussed below. Forpurposes of clarity, the new 3.8% tax on unearned incomewill be referred to in this article as the Medicare Contributiontax or the g3.8% tax.h The tax on earned income forthe funding of Medicare, including the additional .9%,will be referred to as the gHIh (Hospital Insurance) tax.A rate of 3.8% for the Medicare Contribution taxwas chosen by legislators to equal the maximum rate ofthe HI tax that may also apply to a portion of a taxpayerfsearned income beginning in 2013. The 3.8% tax will bepayable in addition to applicable FICA and/or SECAtaxes as well as to the federal income tax.Mechanics of the MedicareContribution Tax CalculationFor individual taxpayers (not including nonresidentaliens), the 3.8% Medicare Contribution tax will applyto an amount that is equal to the lesser of the taxpayerfsnet investment income or the amount of the taxpayerfsmodified adjusted gross income (MAGI) in excess ofthe applicable threshold amount.5 The definition of gnetinvestment incomeh for this purpose will be discussed indetail below. Essentially, net investment income means ataxpayerfs unearned income from investments and accumulatedwealth. Since there is no withholding procedurespecifically applicable to this tax, individuals subject to itshould make estimated payments to avoid interest orpenalties on any additional tax due or increase incometax withholding on their wages to cover any additionaltax payable on unearned income.MAGI, for purposes of the Medicare Contributiontax, means the taxpayerfs adjusted gross income (AGI)without certain tax benefits associated with foreignsource income.6 MAGI appears in other individualincome tax laws and is defined separately for each ofseveral tax rules that are calculated with reference toAGI. The definition under the Medicare Contributiontax applies only with respect to that tax. For the sake ofsimplicity, AGI will be used in this article in reference tothe applicable threshold amounts, under the assumptionthat a taxpayerfs MAGI is generally equal to AGI.The threshold amounts are $250,000 for marriedtaxpayers filing jointly, $125,000 for married taxpayers filingseparately, and $200,000 for other individuals.7 Theseamounts are not currently scheduled to be indexed forinflation. If AGI exceeds the taxpayerfs applicable thresholdamount by more than the amount of the taxpayerfsnet investment income, all of the taxpayerfs net investmentincome will be subject to the 3.8% tax. On theother hand, if the taxpayerfs net investment income isgreater than the amount, if any, by which the taxpayerfsAGI exceeds the threshold amount, then all or part of thetaxpayerfs unearned income will escape the tax.Example 1: Terry and Carol are a married couple filingjointly. In 2013, their AGI is $400,000. Their netinvestment income for the year is $100,000. The 3.8% taxwill apply to the lesser of their AGI in excess of the appli-JOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201140Examining the Unearned Income Medicare Contribution Taxcable threshold amount ($400,000.$250,000, or$150,000) or the amount of their net investment income($100,000). Therefore, all of Terry and Carolfs net investmentincome of $100,000 will be subject to the tax, whichwill be equal to $3,800 for 2013 ($100,000 x .038).Example 2: Don and Louise are a married couple filingjointly. In 2013, their AGI is $300,000. Their netinvestment income for the year is $100,000. The 3.8%tax will apply to the lesser of $50,000 ($300,000 of AGIless the applicable threshold amount of $250,000) or$100,000 (the amount of their net investment income).Therefore, only $50,000 of their $100,000 of net investmentincome will be subject to the tax, which will beequal to $1,900 for 2013 ($50,000 x .038).Example 3: Ron and Sharon are a married couple filingjointly. In 2013, their AGI is $250,000. Their net investmentincome for the year is $100,000. No portion of Ron andSharonfs net investment income will be subject to the 3.8%tax. This is so because the lesser of the amount of such income($100,000) or the excess of their AGI ($250,000) over theapplicable threshold amount ($250,000) is equal to zero.These examples illustrate that even though the 3.8%tax is directly applied only to net investment income, theamount of the taxpayerfs total income, including wages,self-employment income, and any other taxable incomecan create and/or increase exposure to the Medicare Contributiontax. Any type of taxable income can potentiallyresult in more of a taxpayerfs net investment income beingsubject to the 3.8% tax, regardless of whether such taxableincome is net investment income directly subject to thetax. The fact that taxable income not directly subject to the3.8% tax can create exposure to that tax is a basic elementof the landscape that the new tax will create.Since the 3.8% tax on net investment income will becalculated based upon the taxpayerfs total AGI, ratherthan simply on the amount of the net investment incomeitself, it will apply more extensively to the unearnedincome of taxpayers who have both net investmentincome and a relatively high amount of total income,regardless of the character of the income.Example: Shirley, a single taxpayer, has AGI of$200,000 in 2013. All $200,000 of Shirleyfs income is netinvestment income. Although Shirleyfs net investmentincome will be subject to the regular federal income tax, nopart of her income will be subject to the 3.8% MedicareContribution tax. This is because her AGI ($200,000) doesnot exceed her applicable threshold amount of $200,000. If,on the other hand, Shirley also had $100,000 of wages andtotal AGI of $300,000, her AGI would exceed the applicablethreshold amount by $100,000 ($300,000.$200,000).In that case, $100,000 of her $200,000 of net investmentincome would be subject to the 3.8% tax, resulting in a taxliability of $3,800 ($100,000 x .038) in addition to the regularfederal income tax.Application of the Tax to Estates and TrustsEstates and trusts can also be subject to the 3.8%tax. The tax will generally apply to the estatefs or trustfsundistributed net investment income to the extent thatthe taxable income of the trust exceeds the amount atwhich the highest tax bracket applicable to estates andtrusts begins.8 This top-bracket threshold amount is differentfrom the specific threshold amounts based uponfiling status that are applicable to individual taxpayers.The highest tax bracket for estates and trusts beginswhen taxable income exceeds $11,350, as adjusted forinflation for 2011. Taxable income above this amount iscurrently subject to a regular federal income tax of 35%.This top-bracket amount will be subject to inflationadjustments and possibly also legislative changes for 2013.Certain charitable trusts will not be subject to the3.8% tax. So-called gsimple trustsh will also not be subjectto the tax because such trusts have no taxable income. Bydefinition, a gsimpleh trust is one that distributes all of itstaxable income currently, resulting in taxable income ofzero to the entity itself. Grantor trusts will also not be subjectto the 3.8% tax because the income of such trusts istaxed directly to the grantor(s), not to the trust itself.This article will focus more extensively on the applicationof the Medicare Contribution tax to individuals.Comparison to the .9% increase in theHospital Insurance Tax on Earned IncomeAs mentioned above, taxpayers with wages, salaries,or self-employment income above specified thresholdamounts will also be subject to a .9% HI tax in additionto the regular HI tax rate beginning in 2013.9 This taxwill be added to an employeefs portion of the HI tax.JOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201141Examining the Unearned Income Medicare Contribution TaxThere is a withholding requirement applicable to thisadditional amount with respect to employees.10 For selfemployedtaxpayers, any additional .9% tax will beadded to the 2.9% HI tax already payable on net earningsfrom self-employment. Since the .9% increase wasdesigned to be added to an employeefs one-half share ofoverall Medicare taxes, there will be no additional abovethe-line deduction available to the self-employed forthe .9% additional tax.11The applicable threshold amounts for the .9%increase in the HI tax are the same as those that apply tothe Medicare Contribution tax ($250,000 for marriedfiling jointly, $125,000 for married filing separately, and$200,000 for other individuals).12 The additional .9%will apply only to the amount of earned income thatexceeds the applicable threshold. Unlike the MedicareContribution tax, however, the .9% additional HI taxwill be calculated based upon the amount of a taxpayerfsearned income only, rather than the amount of AGI.Therefore, unlike the Medicare Contribution tax, anincrease in taxable income other than the income that isdirectly subject to the .9% additional HI tax will not createor increase exposure to this .9% additional tax.Example: Richard, a single taxpayer, has $280,000of wage income in 2013. He also has $100,000 of netinvestment income for a total AGI of $380,000.$80,000 of Richardfs wages will be subject to the .9%additional HI tax on earned income because his earnedincome exceeds the applicable threshold amount of$200,000 by $80,000. Also, because his AGI is$180,000 more than the applicable threshold for theMedicare Contribution tax ($380,000 . $200,000), allof his $100,000 of investment income will be subject tothe 3.8% tax since his total AGI exceeds $200,000 by anamount ($180,000) that is more than the amount of hisinvestment income ($100,000).In the above example, $80,000 of Richardfs wagesare directly subject to the additional .9% HI tax. Theadditional AGI resulting from his investment incomedoes not increase his exposure to the .9% additional HItax because that tax is calculated with respect to earnedincome only. His earned income does, however, increasehis exposure to the Medicare Contribution tax by raisinghis AGI above the $200,000 threshold.The Nature of the BeastThe 3.8% Medicare Contribution tax is a new applicationto investment income of what has traditionally beenconsidered to be a gpayrollh tax to help fund Medicare.Although it will not be directly applied to earned income,earnings will tend to increase a taxpayerfs exposure to it.Taxpayers with earned income of zero and a significantlevel of investment income will pay the Medicare Contributiontax on net investment income to the extent that theirtotal AGI exceeds the applicable threshold amount. gDollaroneh of a taxpayerfs gnet investment incomeh will not be subjectto the tax unless the taxpayer has other income in additionto net investment income (see the gShirleyh exampleabove). If AGI reaches the level at which the excess of the taxpayerfstotal AGI over the applicable threshold amount isequal to or greater than the taxpayerfs net investment income,100% of net investment income will be subject to theMedicare Contribution tax. No additional increase inincome other than net investment income will create additionalexposure to the Medicare Contribution tax at thatpoint. The range of AGI over which exposure to theMedicare Contribution tax is increased by income otherthan net investment income is a type of income tax gbubble.hExample: Morton, a single taxpayer, has AGI of$425,000 in 2013. His taxable wages are $200,000. Hisnet investment income is $225,000. The amount of hisnet investment income happens to be equal to the excessof his AGI over the applicable threshold ($425,000 .$200,000, or $225,000). Therefore, 100% of his netinvestment income of $225,000 will be subject to theMedicare Contribution tax, which will total $8,550($225,000 x .038%). Any additional income other thannet investment income will not further increase Mortonfsexposure to the Medicare Contribution tax. MortonfsMedicare Contribution tax gbubbleh occurs between thethreshold amount of $200,000 and $425,000 of AGI,since his net investment income is $225,000. Once MortonfsAGI reaches $425,000, 100% of his net investmentincome is subject to the 3.8% tax. At that point,additional income cannot increase exposure to it unlessthe additional income is net investment income.The Definition of gNet Investment IncomehThe income to which the Medicare ContributionJOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201142Examining the Unearned Income Medicare Contribution Taxtax is directly applied is defined as gnet investmentincome.h13 The definition includes gross income frominterest, dividends, annuities, royalties, and rents. Alsogenerally included in this definition is taxable net gainattributable to the disposition of property. Deductionsproperly allocable to such income are permitted to betaken in determining the amount of net investmentincome in generally the same way as is allowable in calculatingthe existing federal income tax. It should benoted that the term gnet investment incomeh for purposesof the Medicare Contribution tax is not defined inprecisely the same way as that same term is definedunder the rules limiting income tax deductions forinvestment interest expenses.14Net investment income includes certain items thatare taxable as ordinary income for federal income taxpurposes (such as interest income) as well as items thatare taxable at capital gains rates (such as long-term capitalgains and dividends under current law).Gross income from a taxpayerfs trade or business, ornet gains attributable to the disposition of property usedin an active trade or business, generally will not be treatedas net investment income.15 Income from certain businesses,however, including passive activities within themeaning of IRC Sec. 469 and certain businesses tradingin financial instruments or commodities,16 will be treatedas net investment income.Any distribution from a qualified retirement plan,including 401(k), 403(b), and 457 plans as well as traditionalIRAs, is also excluded from the definition of netinvestment income.17 Such distributions are typically taxablefor purposes of the existing federal income tax but willnot be directly subject to the Medicare Contribution tax.Distributions from Roth IRAs are also not included in netinvestment income. Qualifying distributions from theseaccounts are not taxable for federal income tax purposes.Gross income from nonqualified annuities isincluded in the definition of net investment income andtherefore directly subject to the tax.18Treatment of Nonqualified Annuity ContractsFor federal income tax purposes, gross income fromnonqualified annuity contracts is generally determinedunder IRC Section 72. Such income includes the taxableportion of loans and withdrawals from such contracts aswell as the taxable portion of annuitized payments.19Gross income also generally includes any gain resultingfrom the surrender of an annuity contract.20 In otherwords, both amounts received as an annuity andamounts not received as an annuity are generally subjectto federal income tax to the extent that such amountsrepresent untaxed gain in the contract.The Medicare Contribution tax statute uses the termgannuitiesh in the definition of net investment income,rather than the term gannuity contract.h21 This terminologyis not completely explicit in defining the types of taxable distributionsthat will be subject to the additional 3.8% tax.It appears quite likely that any taxable portion of distributionsfrom a nonqualified annuity contract, includingannuitized payments, surrenders and other dispositions ofa contract, and loans and other amounts received beforethe annuity starting date will be treated as net investmentincome. Taxpayers might raise an argument, however, thatcertain distributions not received in the form of an annuityshould not be treated as net investment income subjectto the Medicare Contribution tax. The Treasury Departmentcould, at its discretion, issue guidance regarding thespecific application of the tax to annuity contracts.Income that is accumulating on a tax-deferred basiswithin an annuity contract will not be subject to theMedicare Contribution tax during the deferral period.Income that is not included in a taxpayerfs gross incomefor purposes of the existing federal income tax will not besubject to the Medicare Contribution tax.The Medicare Contribution tax statute does notspecifically include taxable distributions from an in-forcelife insurance contract within the definition of net investmentincome. The extent, if any, to which the provisionapplicable to annuities could potentially affect distributionsfrom life insurance contracts is not yet known. Lifeinsurance contracts are customarily distinguished fromannuity contracts under federal income tax law. A taxablesurrender or other disposition of an individually ownedlife insurance contract would, however, appear to beincluded in the definition of net investment income as adisposition of property not held in a trade or business.22These and other issues are not specifically addressedunder the language of the statute. Further developmentsJOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201143Examining the Unearned Income Medicare Contribution Taxregarding the application of this law to insurance productscould provide clarity for both taxpayers and the IRS.How does the Medicare Contribution tax affect thecomparison of a nonqualified deferred annuity to a taxableinvestment account? Funds within a nonqualifieddeferred annuity will avoid the new tax, along with theexisting federal income tax, for as long as the funds areheld within the contract. Funds received from the annuitycontract could be partially or fully taxable dependingupon the nature of the distribution and the extent towhich the contract funds include taxable gain.For taxpayers subject to the Medicare Contribution taxwho expect to have lower levels of income during the yearswhen distributions are taken from a deferred annuity, the3.8% tax could be ultimately reduced or possibly evenavoided by deferring taxation on investment income withinthe annuity contract. Also, if the top federal income tax ratesare increased in the future, deferring a portion of a topbrackettaxpayerfs income to a year when total income will besubstantially lower would become relatively more beneficial.Income tax considerations are just one of many importantfactors involved in the determination of overall suitabilityof the placement of a nonqualified annuity contract.Treatment of Excludible and Tax-Deferred IncomeThe definition of net investment income under theMedicare Contribution tax includes only specified itemsthat are also currently taxable for purposes of the federalincome tax. It does not include any items that are notincluded in gross income under existing federal income taxlaw. Examples of such items include tax-exempt state andlocal bond interest, the receipt of most gifted property, theexcludible amount of gain realized upon the sale of a principalresidence, excludible life insurance death benefits,and qualifying distributions from a Roth IRA account.The definition also does not include income accumulatedwithin tax-deferred accounts or income fromtransactions that qualify as tax-deferred transactionsunder the Internal Revenue Code. Such transactionsinclude but are not limited to like-kind exchanges ofproperty held for business or for the production ofincome,23 tax-deferred exchanges of insurance products,24 and qualifying contributions to the capital of acorporation in exchange for its stock.25 In a tax-deferredtransaction, untaxed gain is typically preserved for taxationat a later date through the application of income taxbasis rules. These rules may result in the untaxed gain inan asset being taxed in a subsequent transaction. In thecase of an excludible item of income, however, theincome generally escapes taxation permanently.Both tax-exempt and tax-deferred income will neitherbe directly subject to the Medicare Contribution tax norincrease potential exposure to it by increasing AGI. As aresult, such items gdo no harmh with respect to the 3.8% tax.Categories of Income under theMedicare Contribution TaxThere are basically three categories of income to beconsidered regarding the Medicare Contribution tax.The most favorable category includes income that is neitherdirectly subject to that tax itself nor subject to theregular federal income tax. Such income will neither bedirectly subject to the 3.8% tax nor increase exposure toit by increasing AGI. As previously described, this categorywill include items that are nontaxable for federalincome tax purposes as well as income that is taxdeferred. Examples of nontaxable items include qualifyingmunicipal bond interest and distributions from RothIRA accounts, as mentioned above. Tax-deferred itemsinclude accumulations within plans of deferred compensation,as well as nontaxable accumulations of incomewithin cash value life insurance and annuity contracts.The preferred tax status of these items will be enhancedupon the arrival of the Medicare Contribution tax.A less favorable category of income for purposes ofthe 3.8% tax includes items that are currently taxable forregular federal income tax purposes but will not bedirectly subject to the Medicare Contribution tax. Theseitems include wages, salaries, self-employment income,and taxable distributions from qualified retirement plans.Such income can potentially increase exposure to theMedicare Contribution tax dollar for dollar for taxpayerswith AGI in certain ranges.Example: Holly is a single taxpayer, age 65. In 2013she has net investment income of $40,000. Her totalAGI for the year has already reached $200,000, theapplicable threshold amount for the Medicare Contributiontax. If Holly takes a taxable distribution of $30,000JOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201144Examining the Unearned Income Medicare Contribution Taxfrom her traditional IRA that increases her AGI to$230,000, she will have to pay an additional 3.8% on$30,000 of her net investment income. The amount ofher AGI in excess of $200,000 ($30,000) is less than hertotal investment income of $40,000. If Holly takes a$60,000 taxable distribution from her IRA instead of just$30,000, and thereby increases her AGI to $260,000, shewill be taxed on all $40,000 of her net investmentincome. The $40,000 would then be less than the excessof her AGI over the applicable threshold amount($260,000 . $200,000, or $60,000).The third and least favorable category of income isnet investment income under the definition discussedabove. Such income will be subject to both the regularfederal income tax and the 3.8% tax to the extent that ataxpayerfs AGI exceeds the applicable threshold amount.Example: Ginny is a single taxpayer with $30,000 ofnet investment income and total AGI of $220,000 in2013. Twenty-thousand dollars of her $30,000 of investmentincome are subject to the 3.8% tax in 2013, since$20,000 is the lesser of her net investment income or herAGI in excess of $200,000. All additional investmentincome that she may receive will be subject to the 3.8%tax. If her net investment income increases by $40,000from a capital gains transaction at the end of the year, herAGI will increase to $260,000. All of the additional$40,000 will be subject to the 3.8% tax in addition tothe previous $20,000, for a total of $60,000 of Ginnyfs$70,000 of investment income. Once Ginnyfs AGIexceeds $200,000, no additional amount of net investmentincome will escape the 3.8% tax.An Overview of the PossibleIncome Tax Landscape in 2013The recent extension26 of certain rate reductionsand other tax benefits enacted in 2001 and 2003 (oftenreferred to as the gBush tax cutsh) is currently scheduledto expire as of January 1, 2013, the same time as theMedicare Contribution tax is scheduled to begin. It ispossible that those tax benefits will either be extendedfurther or made permanent. It is also possible that theywill be allowed to expire, or that new and different revenue-raising provisions will be enacted. Predicting futuretax laws is always a perilous pursuit. For purposes ofthought and discussion, the following is an overview ofhow things could look in 2013 if the tax provisions ofhealth care reform are left intact and the tax cut extensionsare permitted to expire at the end of 2012.Combined Tax Rates on Net Investment IncomeIf the current maximum tax rate of 15% on mostlong-term capital gains of individual taxpayers simplyexpires in 2013, the maximum rate would return to itsprevious level of 20%.27 The maximum tax rate on ordinaryincome, which would generally apply to both taxableinterest income and dividend income in 2013 withoutfurther legislative changes, would increase to 39.6%from the current rate of 35%.Assuming that a taxpayerfs investment income will besubject to both the highest rate of federal income tax andthe Medicare Contribution tax, a cumulative rate of 23.8%(.2 + .038) could potentially be applicable to net investmentincome from items taxed at capital gains rates, and arate of 43.4% (.396 + .038) to net investment incomeattributable to items taxed at ordinary income rates.Such an increase in the cumulative maximum capitalgains rate would represent a 59% increase in comparativepercentage terms [(.238 . .15)/.15]. For ordinaryincome, the rate increase in percentage terms would be24% [(.434 . .35)/.35]. In nominal terms, the increasewould be 8.8% for capital gains (or $8,800 per $100,000of gains) and 8.4% for net investment income taxed asordinary income (or $8,400 per $100,000 of income).Note that as adjusted for inflation in 2011, the topmarginal tax rate of 35% is applied to taxable income inexcess of approximately $380,000 for individual taxpayersother than those who are married filing separately. Taxableincome generally equals AGI minus itemized deductions(or the standard deduction) and allowable personaland dependency exemptions. Taxpayers subject to thehighest marginal rate in 2013 will almost certainly haveAGI substantially in excess of the applicable threshold fordetermining exposure to the Medicare Contribution tax.Other Potential Tax Increases in 2013A number of other provisions that would result in taxincreases are also currently scheduled to return to applicablelaw in 2013 if the tax cut extensions simply expire.JOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201145Examining the Unearned Income Medicare Contribution TaxThese include the phaseout of itemized deductions (otherthan medical expenses, casualty losses, investment interestexpenses, and gambling losses) and the phaseout ofpersonal and dependency exemptions.28 Both of thesephaseouts were applied to upper-income taxpayers underprior law, using threshold amounts of AGI as levels atwhich the reduction or elimination of these tax benefitswould incrementally occur. If the phaseout of personaland dependency exemptions had returned in 2011instead of being delayed to 2013 by the tax cut extensions,a married taxpayer filing jointly would have beensubject to a reduced exemption amount when AGIexceeded approximately $254,000, as adjusted for inflation.This amount is very close to the prospective thresholdfor exposure to the Medicare Contribution tax.Under the health care reform law, an increase in themedical expense deduction gfloorh from 7.5% of AGI to10% of AGI is also scheduled to take effect in 2013 fortaxpayers under age 65 (and for those 65 and over in2017).29 For married taxpayers filing jointly with onespouse 65 or over, the increase takes effect in 2017. Thisincrease in the deduction floor would decrease total medicalexpense deductions available as itemized deductions,since it would increase the amount of deductions noteligible to be claimed. It would also make the medicalexpense gfloorh the same for regular federal income taxpurposes as for purposes of the alternative minimum tax.Other approaches to further restricting the tax benefitsof itemized deductions are currently under considerationby the government. Most itemized deductions,including those that would not be subject to the deductionphaseout, are already subject to specific restrictionsbased upon AGI or other limiting factors.Restrictions on the calculation of itemized deductionsand exemptions do not affect the calculation of AGI.Itemized deductions and personal exemptions are claimedin the calculation of taxable income after AGI has alreadybeen determined. Even so, the loss of all or a portion ofpreviously allowable deductions is another type of taxincrease. If these deductions are further limited, the overalleffective rate of tax will rise for many taxpayers. Furthermore,since many itemized deductions are reduced asa taxpayerfs AGI rises, taxpayers subject to the MedicareContribution tax will also have these deductions scaledback. Although itemized deductions and exemptions donot affect the calculation of AGI, they are affected by it.Other tax increases will occur in 2013 if the tax cutextensions expire. These include limits or reductions in thetax credit for children, the adoption credit, the credit forhigher education expenses, and others. An in-depth discussionof these specific provisions is beyond the scope of thisarticle. It should be understood, however, that theMedicare Contribution tax may arrive as part of a generalenvironment of tax increases that could add considerablyto the burden of upper-income taxpayers, and to a lesserextent, all taxpayers. If the goals of reducing the federaldeficit and funding promised benefits under Medicareand Social Security are to be accomplished, the money hasto come from somewhere. The Medicare Contributiontax, or something similar to it, could gain a foothold in thetax law regardless of the ultimate fate of health care reform.Techniques for Avoiding theMedicare Contribution TaxFundamental strategies for avoiding or reducing theMedicare Contribution tax include reducing the amountof a taxpayerfs AGI and reducing the amount of netinvestment income subject to the tax.Reducing AGILegitimately managing a taxpayerfs AGI is a cornerstoneof individual income tax planning. A wide varietyof tax benefits decreases as AGI rises.30Deductions that are available in the process of calculatingAGI are often referred to as gabove-the-linehdeductions. They are subtracted from gross income incalculating AGI and can therefore help to reduce exposureto the Medicare Contribution tax. Such expensesinclude alimony payments, deductible IRA contributions,and other items.Allowable business expenses or losses claimed onSchedules C and E of Form 1040, and also on Line 14 ofForm 1040 (with Form 4797), can substantially reduceAGI. AGI can also be reduced by making deductiblecontributions to qualified plans of deferred compensation.For taxpayers whose income is higher than the applicableAGI threshold for determining exposure to theMedicare Contribution tax, reducing AGI to a level atJOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201146Examining the Unearned Income Medicare Contribution Taxwhich the amount of net investment income is greaterthan the excess of AGI over the applicable threshold willhelp to avoid the tax.Example: Mike is a single taxpayer. His earnedincome is $225,000 per year. He also has net investmentincome of $300,000. Mikefs AGI for 2013 is $525,000.All of his $300,000 of investment income will be subjectto the 3.8% tax because the amount of such income is lessthan the excess of his AGI over his $200,000 thresholdamount ($525,000 . $200,000, or $325,000). If Mike isable to reduce his AGI by $75,000 by retirement plancontributions and above-the-line deductions, he will have$450,000 of AGI instead of $525,000. This would resultin $250,000 ($450,000 of AGI . $200,000 thresholdamount) of his investment income being subject to theMedicare Contribution tax, instead of the entire$300,000. That tax would be reduced by $1,900($50,000 x .038%). Mikefs regular federal income taxwill also be decreased as a result of reducing AGI.Some taxpayers may not be able to reduce theamount of their AGI to a level below that at which theirnet investment income is equal to the amount of AGI inexcess of the applicable threshold amount under theMedicare Contribution tax. These individuals will not beable to reduce exposure to the 3.8% tax, although anyreduction to AGI will still decrease federal income tax.Example: Ike is a single taxpayer. His earned incomeis $500,000 per year. His net investment income is$300,000. In 2013, Ikefs AGI is $800,000. If Ike is ableto reduce his AGI by $100,000 by retirement plan contributionsand above-the-line deductions, his AGI will be$700,000. This will reduce his regular federal incometax. However, the excess of his AGI over the applicablethreshold amount ($700,000 . $200,000, or $500,000)is still more than the amount of his investment incomeof $300,000. Therefore, this reduction in Ikefs AGI willnot decrease his exposure to the Medicare Contributiontax, although it will decrease his overall income tax.Reducing Net Investment IncomeAnother way of reducing exposure to the 3.8% taxis to reduce the amount of net investment income thatthe taxpayer receives. Such a reduction will directlydecrease the Medicare Contribution tax otherwisepayable. This approach would typically involve changesto an individualfs investment portfolio.It should be noted that possible strategies for allocatinginvestments among asset classes and availableaccounts are suggested here only in the narrow context ofthe specific income tax considerations described. Nostrategies should be recommended to any individualwithout a comprehensive analysis of the individualfsfinancial situation, investment objectives, incomerequirements, and tolerance for risk.For some taxpayers it could be helpful to gharvesthor realize some taxable capital gains in 2011 and/or 2012by selling selected equity or debt investments in taxableaccounts. This would avoid the Medicare Contributiontax on the capital gain portion of the proceeds, as well aspotentially higher maximum capital gains rates after2012. The proceeds could be reinvested in either a similaror different type of investment consistent with theparticular taxpayerfs investment objectives. If the investorwishes to reduce net investment income after 2012 tohelp avoid the Medicare Contribution tax, assets that payminimal levels of taxable income annually could be considered.Such assets would include tax-efficient or taxmanagedequity investments, tax-exempt bonds, or certainreal estate and other tangible assets.Dividends on equity investments in taxable accountscould once again become taxable at ordinary incomerates rather than capital gains rates in 2013. As previouslydescribed, dividends could be subject to a maximumstatutory tax rate of 39.6% at that time, along with theadditional 3.8% Medicare Contribution tax. Underthose circumstances, equity investments that pay dividendswould become relatively less favorable when placedin a taxable account and relatively more favorable in atax-deferred account after 2012. The same would betrue for other investments yielding unearned incomethat would be both taxable as ordinary income and subjectto the Medicare Contribution tax. Investors withaccess to both taxable and tax-deferred accounts maybenefit from reallocating asset classes among theseaccounts, without necessarily making a significant changein overall portfolio diversification. The Obama administrationhas recently proposed31 that qualified dividendscontinue to be taxed at the rates applicable to long-termJOURNAL OF FINANCIAL SERVICE PROFESSIONALS / MAY 201147Examining the Unearned Income Medicare Contribution Taxcapital gains after 2012. This statement of policy makesit somewhat more likely, yet still far from certain, thatdividends will remain taxable at long-term capital gainsrates in the future. Congressional action would beneeded to keep such treatment in place after 2012.For taxable accounts, municipal bonds yielding taxexemptinterest will become relatively more beneficial fortop-bracket taxpayers after 2012 as compared to bondsyielding taxable interest. This comparison would bebased in part upon the interest rate differential betweenthese two investments at that time.Tax-deferred accounts can be used to avoid taxationuntil a distribution is made from the account. Forretirement accounts other than Roth accounts, however,distributions will typically be taxable as ordinary incomeand possibly increase exposure to the Medicare Contributiontax, even though such distributions will not bedirectly subject to that tax.A decision to convert a traditional IRA account to aRoth account involves many complex elements. Thatequation could be further complicated with the arrival ofthe Medicare Contribution tax and higher maximumtax rates in 2013. Roth conversions in 2011 or 2012would be relatively more favorable than conversions after2012 under these circumstances. A conversion before2013 would increase the account ownerfs AGI in theconversion year, but would not create exposure to the3.8% tax. Also, qualifying distributions from the Rothaccount after 2012 would neither be subject to that taxitself nor increase exposure to it by increasing AGI.ConclusionEven though 2013 will not arrive for some time,taxpayers and advisors should begin to understand andto consider the potential effects of the Medicare Contributiontax. Although tax law changes cannot be predictedwith any degree of certainty, it is very possiblethat income taxes will rise in the future. For upperincomeindividuals, it is advisable to anticipate the effectof the Medicare Contribution tax as a part of the processof investment, tax, and retirement planning over thecurrent planning horizon. ¡James F. Ivers III, JD, LLM, ChFC, is an educator specializing infederal income taxation, and an adjunct professor of taxation atThe American College in Bryn Mawr, Pennsylvania. He has professionalexperience in estate, gift, and income taxation as wellas in business and personal financial planning. He may bereached at .(1) The Patient Protection and Affordable Care Act, Pub. L. No. 111-148, and the Health Care and Education Reconciliation Act of 2010,Pub. L. No.111-152.(2) IRC Sec. 1411, added by Sec. 1402(a)(1) of the Health Care andEducation Reconciliation Act of 2010.(3) IRC Sec. 164(f ), IRC Sec. 1402(a)(12).(4) IRC Sec. 3101(b)(2), as amended by Sec. 9015(a)(1) of the PatientProtection and Affordable Care Act; IRC Sec. 1401(b)(2)(A), as amendedby Sec. 10906(b) of the Patient Protection and Affordable Care Act.(5) IRC Sec. 1411(a)(1).(6) IRC Sec. 1411(d).(7) IRC Sec. 1411(b).(8) IRC Sec. 1411(a)(2).(9) IRC Sec. 3101(b)(2).(10) IRC Sec. 3102(f )(1).(11) IRC Sec. 164(f )(1).(12) IRC Sec. 3101(b)(2)(A),(B),(C).(13) IRC Sec. 1411(c).(14) That definition is set forth in IRC Sec. 163(d)(4).(15) IRC Sec. 1411(c)(1)(A)(i),(iii).(16) IRC Sec. 1411(c)(2)(B), referencing IRC Sec. 475(e)(2).(17) IRC Sec. 1411(c)(5).(18) IRC Sec. 1411(c)(1)(A).(19) IRC Sec. 72(a),(b),(e).(20) IRC Sec. 72(e)(5)(E).(21) IRC Sec. 1411(c)(1)(A)(i).(22) IRC Sec. 1411(c)(1)(A)(iii).(23) IRC Sec. 1031.(24) IRC Sec. 1035.(25) IRC Sec. 351.(26) The Tax Relief, Unemployment Insurance Reauthorization and JobCreation Act of 2010, Pub. L. No. 111-312.(27) IRC Sec. 1(h), as amended by Sec. 102(a) of the Tax Relief, UnemploymentInsurance Reauthorization and Job Creation Act of 2010.(28) IRC Secs. 68(g) and 151(d)(3), as amended by Sec. 101(a)(1) of theTax Relief, Unemployment Insurance Reauthorization and Job CreationAct of 2010.(29) IRC Sec. 213(a),(f ), as amended by Sec. 9013 of the Patient Protectionand Affordable Care Act.(30) These include the tax credit for children, the credit for child care expenses,the adoption credit, the credits for higher education expenses, rules for deductibleIRA contributions and contributions to Roth IRAs, the rental real estate gactiveparticipationh exception to the passive loss limitations, and many others.(31) General Explanation of the Administrationfs Fiscal Year 2012 RevenueProposals (Department of the Treasury, February 2011).