Financial Abundance

The health care bill, enacted in March, includes two new Medicare taxes on the “wealthy.’  While you may not consider yourself wealthy, there is a reasonable chance that you may have the opportunity to pay one or both of these taxes.  Let’s examine these new Medicare taxes to determine if they might be part of your financial future.

The first tax is a 62% increase (from 1.45% to 2.35%) in Medicare taxes for individuals with earned income over $200K and for couples with earned income over $250K.  While a single person earning over $200K per year is highly compensated, couples need only earn more than $125K each to be engulfed by this new tax.  As usual, the minimum earnings amount is not tied to inflation.  If 1970s style inflation appears in the next few years, earnings of over $125K may become much more common.

The second Medicare tax on the “wealthy” is a 3.8% tax on investment income for singles with an Adjusted Gross Income (AGI) exceeding $200,000 and couples with an AGI exceeding $250,000.   Let’s look at a scenario in which a couple whose earnings are less than $250K could end up paying almost $75K for this new tax.

You and your spouse are 60 years old and owners of a small Sub Chapter S Corporation.  Your joint salaries total $175K.  Through diligent saving over the past 35 years and a small inheritance, you have $1 million dollars in investments to help provide for a reasonable standard of living in your retirement years.

In 2013, the economy finally begins to recover and your business booms, throwing off $75K in dividend income.  At the same time, the stock market finally recovers and you have a 15% return on your investments.

Your AGI from salary and company dividends in 2013 is $250K.  Because of this “wealth,” the $150K in investment income from your savings would be taxed at the then current income tax rate plus you would pay an additional $5,700 in Medicare taxes.

After paying these high taxes in 2013, you decide to sell your business and retire in 2014.  The business sells at the end of 2014 for $1 million.  In 2014 your salaries and dividends from the business total $200K and your investments provide an 8.7% return of $100K .

For 2014, your AGI from salary and company dividends in 2013 is $200K, while your total investment gains (including the sale of your company) are $1.1 million.  The new 3.8% Medicare tax on the “wealthy” would cost you an additional $39,900 above your already high 2014 taxes.

In 2015, you decide to downsize your house, built in 1975 at a cost of $40,000, as well as sell your ski condo that you bought in 1980 for $60K.  Living in Boulder, your house sells for $940K and your condo sells for $460K.  While you have $0 earned income, your investment portfolio increases by approximately 10%, providing $200K in investment income.  Even with the $500K capital gains exclusion for the sale of your home, your total taxable investment income in 2015 is $1 million.  Since $750K of the investment income is taxed at the additional 3.8% rate, the new Medicare tax adds $28,500 to your 2015 tax bill.

The small business owners in the above scenario would hardly be considered “wealthy.”  However, in three years, this couple could pay $74,100 in additional Medicare taxes, thanks to health care reform.

There are several ways that this couple could reduce their taxes, but they did not even know about these new Medicare taxes.  As our government needs more and more tax revenue to sustain its profligate spending, tax planning becomes even more critical.

The good news is that these new taxes do not become effective until 2013.  If you are planning on selling your business or home, tax planning now could save you thousands of dollars in taxes later.  Now, more than ever, it is important to do advanced tax planning with a financial professional who fully understands the tax system.  As our example shows, not understanding the new tax laws can be very expensive.