By Thomas J. Connelly, CFA, CFP

The 3.8% Medicare surtax on investment income that starts in 2013 is the primary issue here.  The mitigation or avoidance of this surtax is achieved by the employment of two tactics; reducing investment income and/or reducing MAGI (modified adjusted gross income), while managing the Medicare crossover zone (around the threshold amount).  Please refer back to last quarter’s article for explanation on how this tax is calculated.  As a review, if MAGI exceeds the threshold amount ($250,000 for married filing jointly, $200,000 for single and head of household), then you have the potential to pay this surtax on your net investment income.  Think of MAGI as comprised of two parts; 1- Net Investment Income and 2- Other income.  The ability to adjust either or both of these two components potentially allows you to minimize the surtax.


Potential ways to reduce net investment income are:

1)   Use tax-exempt bonds – We’ve always used tax-exempt bonds for 25% tax brackets and higher since this maximizes the after-tax return compared to taxable bonds, but the surtax adds a new parameter to the investment selection decision.

2)   Utilize qualified plans and IRAs, which provide tax-deferred income.

3)   If one still has significant disposable income, the use of tax-deferred annuities may make sense.  One must be careful in selecting an annuity product that minimizes the costs (annuity and mortality) associated with this product.  This tactic is more beneficial when you are trying to tax defer and shift income from “wage years” to “retirement years” where income from annuitizing the annuity will not create a Medicare surtax in the future.

4)   Non-qualified Deferred Compensation – It is still unclear at this point if deferred compensation will be excluded from the net investment income calculation.  If it is, however, one could use it to reduce income in their later working years and use the deferred compensation to supplement their retirement needs thereby reducing/avoiding the surtax.

5)   Life Insurance – If one has a need for life insurance, the use of after-tax dollars to fund the policy would reduce investment income.  Growth within the policy is tax-deferred and principal can be withdrawn in later years tax-free (this is considered a loan with its associated costs).  Since insurance products typically have higher cost structures, one needs to weigh them against any potential surtax savings.

Potential ways to reduce MAGI are:

1)   Reduce net investment income using techniques stated above.

2)   Make Roth Conversions in 2010, 2011, and 2012 before the surtax hits in 2013.  As explained in the prior article, distributions from Roth IRAs do not add to MAGI.  Roth IRAs also do not have Required Minimum Distribution (RMDs) as traditional IRAs do.  Thus, this new surtax adds an extra dimension to the Roth Conversion strategy.  Please refer to the 2009 3rd Quarter letter for a comprehensive look at Roth conversions.  The removal of income limitation on Roth conversions and the impact of the Medicare surtax has triggered this a  strategy that could provide income and  estate tax benefits over the long term.

3) Utilize sophisticated trust techniques (see Estate Planning opportunities above) that both provide estate tax minimization and reduce MAGI.

One last issue is that taxpayers need to review the tax impact of accumulation versus distribution of income in irrevocable trusts.  Trusts have a much lower income limit for the imposition of the surtax as compared to individual taxpayers.  So, you need to assess if accumulation or distribution from trusts minimize overall tax liability.



As you can see, there are a lot of moving parts that must be assessed to meet one’s financial goals and objectives with respect to the minimization of taxes going forward.  Major income events, such as employment bonuses, significant capital gains incurred from the sale of investments or a business, the exercise of non-qualified stock options, and Roth conversions, must be prudently evaluated in the context of tax minimization.  Many of these tactics potentially impact investment strategy.  As the old saying goes “Do not let the tax tail wag the investment dog.”  Therefore, everyone needs to assess their own personal situation in a holistic and optimal fashion.

We strongly urge all of our clients to use the rest of 2010 to enact a proactive stance to the tax planning opportunities that face all of us. This complex analysis requires the coordinated use of all of your professional advisors; Versant, your CPA/tax consultant and your estate planning attorney.  We are committed at Versant to work with you and your other advisors to personally address your situation and to help implement the appropriate plan for you.

Disclosure: Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Versant Capital Management, Inc.), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Versant Capital Management, Inc.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Versant Capital Management, Inc. is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  If you are a Versant Capital Management, Inc.  client, please remember to contact Versant Capital Management, Inc., in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Versant Capital Management, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.