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High-Earners Will Pay High Taxes in 2016

Posted by Russell E. Towers on 28 Nov 2016
Russell E. Towers

Certain high-earners face a double-barreled shot of federal income taxes for 2016. The maximum marginal tax rate for these high-earners remains at 39.6% in 2016 and the provisions of the Affordable Care Act (aka ObamaCare) are still in effect.

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For some high earners, the Affordable Care Act provides for an additional 3.8% health care surtax on passive investment income under IRC Section 1411. There are different definitions of who is classified as a “high-earner” that will be subject to these tax rates.

Summary of who will pay income taxes at the highest rate in 2016:

  • For married couples with total taxable income (“below the line” AFTER itemized deductions) greater than $466,950 and single individuals with taxable income greater than $415,050, their top marginal tax rate will be 39.6%.
  • These tax brackets are indexed for inflation just as the income tax rates have been indexed since the early 1980s.
  • For married couples with total taxable income greater than $466,950 and single individuals with taxable income greater than $415,050, long term capital gain income and qualified dividend income will be taxed at a rate of 20% instead of 15% for taxable incomes below those thresholds.

Summary of who will pay the 3.8% surtax in 2016 based on the Affordable Care Act:

  • For married couples with modified adjusted gross income (“above the line” BEFORE itemized deductions) in excess of $250,000 and single individuals with modified adjusted gross incomes in excess $200,000, they will pay an additional 3.8% health care surtax on their “passive” investment income.
  • These $250,000 and $200,000 thresholds are NOT indexed for inflation.
  • Passive income is defined as interest, rents, royalties, and taxable annuity amounts. These items are “passive” income taxed at ordinary income rates as high as 39.6%.
  • Passive income is also defined as long term capital gains and qualified dividends. These items are “passive” income taxed at the capital gain / dividend rates of 15% or 20%.

Combined Effect of Top Tax Rates for Ordinary, Capital Gain, and Passive Income

Here is a summary of the 2016 combined effect for those who will be subject to the highest tax rates. The $466,950 / $415,050 threshold (indexed) is based on excess “Taxable Income” above the threshold.  The $250,000 / $200,000 threshold (not indexed) of the Affordable Care Act is based on excess “Modified Adjusted Gross Income” (MAGI) above the threshold.

 

Top Tax Rate

 

Health Care Tax

 

Top Total Rate

Earned Income, Interest, Rents, Royalties, Taxable Annuity Amounts (Ordinary Income)

39.6%

+

3.8%

=

43.4%

Long Term Capital Gain and Qualified Dividends – MAGI Married $250,000 / Single $200,000 

15%

+

3.8%

=

18.8%

Long Term Capital Gain and Qualified Dividends – Taxable Income Married $466,950 / Single $415,050     

20%

+

3.8%

=

23.8%

Additional Important Notes Regarding “Passive” Investment Income

  • “Passive” investment income under the Affordable Care Act is defined2017 specifically as the LESSER of net investment income OR the excess of modified adjusted gross income (MAGI) over the threshold amount (i.e. $250,000 married / $$200,000 single).
  • There are some common types of income that are NOT considered “passive” investment income. This includes wages, salaries, and bonuses (i.e. earned income), Social Security benefits, tax exempt interest, excluded gain on the sale of a personal residence, distributions from any type of a qualified retirement plan or IRA, and tax free Roth IRA distributions.
  • However, keep in mind that taxable distributions from qualified plans and IRAs, and taxable amounts from IRA conversions to Roth IRAs will increase modified adjusted gross income and could trigger the 3.8 % tax for those with total income over the threshold amounts.

Example #1: 3.8% Health Care Tax (Investment Income GREATER Than Excess MAGI Over Threshold)

Assume married taxpayers have modified adjusted gross income (MAGI) of $300,000 which includes “passive” investment income of $100,000.  Since they are over the threshold of $250,000, they are subject to the additional 3.8% surtax. 

  • The excess of $300,000 MAGI over the $250,000 threshold = $50,000
  • The surtax tax applies to the LESSER of the excess MAGI over the threshold ($50,000) or the amount of net “passive” investment income ($100,000).
  • So, the extra tax will be $50,000 x 3.8% = $1,900

Example #2: 3.8% Health Care Tax(Investment Income LESS Than Excess MAGI Over Threshold)

Assume these same married taxpayers have modified adjusted gross income (MAGI) of $400,000 which includes “passive” investment income of $100,000.  Since they are over the threshold of $250,000, they are subject to the additional 3.8% surtax.

  • The excess of $400,000 MAGI over the $250,000 threshold = $150,000
  • The surtax tax applies to the LESSER of the excess MAGI over the threshold ($150,000) or the amount of the net “passive” investment income ($100,000).
  • So, the extra tax will be $100,000 x 3.8% = $3,800

The Effect of Higher Combined Tax Rates on Choice of Financial Assets

As combined tax rates of high earners increase (add state income taxes to combined federal rates), this will cause clients to consider certain types of financial assets more favorably. Tax deferred and tax free financial assets become more attractive the higher the combined income tax rate on other alternative financial assets.  For certain “high earners” in 2016, their combined federal and state marginal tax rate can approach or exceed 50%.

Certain tax-favored financial products that will be even more attractive as combined income tax rates rise for “high earners” generally fall into these categories:

  • Non-qualified fixed and indexed annuity products where the account value gain is tax deferred and withdrawals are taxed under the (LIFO) method of taxation
  • Non-MEC cash accumulation type of universal, indexed, or whole life insurance where the cash value gain is tax deferred, withdrawals to basis (FIFO) and loans are tax free, and the death benefits are tax free
  • Maximizing tax deductible and elective deferral contributions to qualified retirement plans like 401(k), 403(b), 457(b), IRA, SEP plans, Profit Sharing plans, and Defined Benefit plans
  • “Standalone” long term care policies where the premium is either fully deductible or partially deductible to C Corp, S Corp, and LLC business owners and where any long term care benefit claim payments are tax free

Technical Note: At this time, it is unclear whether any ordinary income taxation on life insurance policies will be considered “passive” investment income subject to the 3.8% surtax.  IRC Section 1411(c) does not specifically mention life insurance under the definition of net investment income.  However, a liberal reading of the wording of IRC Section 1411(c)(1)(A)(iii) … (“net gain attributable to the disposition of property”) … could bring any income taxation of certain life insurance transactions under the definition of net investment income for purposes of the 3.8% surtax.  Life insurance would seem to be a form of “property” that could incur a “net gain” under certain circumstances:

  • Surrender of a policy in a gain position;
  • Elimination and discharge of a policy loan in the process of a Section 1035 exchange;
  • Lapse of a heavily loaned policy in a gain position;
  • Withdrawals in excess of cost basis;
  • LIFO withdrawals / loans from a modified endowment contract MEC in a gain position;
  • “Force-outs” in the first 15 years from a policy under the IRC Section 7702(f)(7) definition of life insurance;
  • A sale of a policy in a gain position to a life settlement company.

All of these taxable transactions will generate a Form 1099-R to the policy owner with a copy to the IRS.

Contact a BSMG Life Insurance or Annuity Advisor to review our competitive annuity and life insurance products that can help shield high-earners from the high combined tax rates in 2016.  Life insurance and annuities should comprise part of the asset portfolio of these high-earners so they can keep more of what they earn for themselves and their families.

 

Russell E. Towers JD, CLU, ChFC
Vice President – Business & Estate Planning
Brokers' Service Marketing Group
russ@bsmg.net

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Topics: Tax Season, Tax Planning