This is Part II of our mid-year tax planning information. In Part II we cover the:
- New medicare tax increases,
- Need to make estimated tax payments,
- Whether you should consider a Health Savings Account (HSA).
Making time for 2013 tax planning now not only helps reduce your taxes, but also helps to put you in control of your entire financial situation. Tax planning should be a year-round process, but it’s especially effective at midyear. Give us a call for guidance in implementing the best moves for your particular situation.
Determine whether the new Medicare taxes apply to you
This year higher-income taxpayers may need to factor additional Medicare taxes into their planning. Not only will the Medicare tax increase on earned income above certain levels, but also a new tax will apply to certain investment income.
The traditional Medicare tax has been 2.9% of earned income for self-employed people and 1.45% for employees (with an additional 1.45% paid by employers on their employees’ wages). Under the new law, both self-employed people and employees owe an additional 0.9% on annual earnings above $200,000 for singles or $250,000 for joint filers. Employers don’t owe additional taxes on their employees’ earnings, but they’re responsible for withholding the 0.9%.
If your investment income exceeds certain thresholds, you may owe a 3.8% Medicare tax on the excess. The taxable amount would be the lesser of (a) your net investment income, or (b) the excess of your “modified adjusted gross income” (MAGI) above $200,000 for singles, $250,000 for spouses filing jointly, or $125,000 for spouses filing separately.
“Net investment income” includes interest, dividends, capital gains, rents, royalties, non-qualified annuities, and income from passive activities. It excludes earned income, social security benefits, tax-exempt interest, and distributions from qualified retirement plans. MAGI is adjusted gross income increased by certain deductions and exclusions.
To help minimize these two new taxes, consider the following strategies:
On earned income
• If your earnings fluctuate and you’re approaching the threshold, try to defer excess compensation to the following year.
• If you’re married, consider increasing your withholding to cover your joint Medicare liability.
• The tax applies to net income, so if you’re self-employed, consider accelerating large deductible expenditures into high-income years.
On net investment income (NII)
• Where possible, use capital losses to offset capital gains.
• Consider investing in tax-deferred annuities, municipal bonds, or other vehicles that don’t generate taxable income.
• Maximize deductible contributions to traditional IRAs, 401(k) plans, or similar sheltered investments. Earnings in these accounts are not included in NII, and the contributions will reduce your MAGI.
• Donate appreciated stocks to charities rather than generating capital gains by selling them.
• Make normally taxable investments through a Roth IRA to the extent possible. The earnings won’t be part of NII, and subsequent tax-free withdrawals won’t count toward the thresholds.
The new rules for Medicare taxes are complicated and still evolving. If you think you’ll be affected, call soon for a planning appointment.
Consider a health savings accounts
Year after year, health care and medical insurance costs outpace inflation. One survey, for example, found that health insurance premium costs are growing at five times the rate of wages. It’s little wonder, therefore, that business owners and employees are scrambling for ways to curtail health care expenses. In an effort to address this dilemma, Congress passed the Medicare Prescription Drug and Modernization Act of 2003, which allowed employers to offer health savings accounts or HSAs.
• How HSAs work? An HSA works in tandem with a high-deductible health plan (HDHP). To qualify as an HDHP, the policy’s deductible (for the 2013 tax year) must be at least $1,250 for an individual or $2,500 for a family. You sign up for an HDHP policy with an insurance company and an HSA with your employer. Throughout the year, you deposit money in your HSA using pre-tax dollars, subject to certain limits on annual contributions. (For 2013, HSA contribution limits are $3,250 for individuals and $6,450 for families.)
When medical bills come due, you’re allowed to withdraw money from this account, tax-free, to cover out-of-pocket costs, including your deductible, payments for prescription drugs, and medical bills not covered by your insurance policy.
• HSAs compared to FSAs. How does an HSA differ from a flexible savings account (FSA)? For one thing, there’s no requirement that you “use or lose” HSA contributions by the end of the year. You can leave the money in an HSA and allow it to grow tax-free until needed. In addition, an HSA is portable. You can take it with you if you change employers (not so with an FSA). Moreover, if you don’t need the money for current medical bills, you’re allowed to invest HSA contributions and earnings in a variety of mutual funds and other investments.
• The business side. Businesses, too, might want to consider HSAs. The employer’s portion of insurance expense may be reduced because insurance premiums tend to be lower with high-deductible health plans. By contributing to HSAs, workers also may be encouraged to become more prudent consumers of health care services and better stewards of their own health. This, in turn, may reduce business costs related to employee sickness.
• For some people, however, an HSA may not be the best option. Changing insurance policies may be fraught with risk if you or a family member suffer from a chronic health problem such as diabetes or cancer. And if you’re under age 65 and want to withdraw money from an HSA to cover non-medical expenses, the withdrawals will be subject to income tax and a hefty 20% penalty.
So it’s important to consider health savings accounts from every angle. If you’d like more information about HSAs, give us a call.
Estimated Taxes
Who needs to pay them?
If the bulk of your taxable income is from wages, your tax liability is probably being covered by withholding from your paychecks. However, if you have income that is not subject to withholding, you may need to pay quarterly tax estimates.
Many taxpayers who switch from being an employee to being self-employed find out about the quarterly estimate requirements after it is too late. Along with income tax, self-employed individuals must include FICA taxes in their tax estimates.
If you have acquired income-producing property, you may have a tax increase that is large enough to require quarterly estimates. Quarterly payments may be necessary even though taxes are being withheld from your wages or retirement income.
If you fail to pay required income tax estimates on time, the result may well be a penalty plus interest. Here are the rules.
• General rule. The general rule is that at least 90% of your income tax must be prepaid either by withholdings or by estimated tax payments. If you fall short of that, you may be able to avoid penalties if you meet the “safe harbor” rules.
• Safe harbor rules. Taxpayers with adjusted gross income (AGI) of $150,000 or less can avoid underpayment penalties by prepaying an amount equal to 100% of last year’s tax liability. Those with AGI of over $150,000 must prepay 110% of their prior-year tax liability.
There’s no penalty if your underpayment is less than $1,000. Special rules apply to farmers and fishermen.
• Due dates. The first quarterly payment for 2013 was due on April 15. The second payment due date is June 17, and the third is September 16. The final 2013 payment is due on January 15, 2014.
If you have a significant change in your income from last year, you may want to review your estimated payments. If the new Medicare surtaxes will hit you, your estimated taxes may also be affected. We will gladly assist you in determining your prepayment requirements.
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IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with Treasury Department regulations, we inform you that any U.S. federal tax advice contained in this correspondence (including any attachments) is not intended or written to be
used, and cannot be used for the purpose of (i) avoiding penalties that may be imposed under the U.S. Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Jack Craven, CPA