Gift Planning and the Medicare Surtax

Looking ahead to 2013, there are a few tax increases on the horizon that will affect gift planning. In particular, the Bush tax cuts are scheduled to expire at the same time new tax increases are scheduled to take effect.

  • The scheduled expiration of the income, qualified dividends, and capital gains tax cuts enacted in 2001 and 2003 will bring back the 39.6% top income tax rate and the 20% top tax rate on most types of long term capital gains.
  • The recently increased $5,120,000 million exemption amount for estate, gift, and generation skipping transfer taxes and 35% top tax rate are also scheduled to sunset and return to the pre-2001 law $1 million exemption amounts and 55% top tax rate.
  • A new .9% Medicare surtax on earned income above $250,000 for married couples and $200,000 for single persons increases Medicare taxes from 2.9% to 3.8% for self-employment income, and from 1.45% to 2.35% on the employee share of Medicare tax for high wage earners (employer share remains 1.45%).
  • A  3.8% Medicare surtax is applied to net investment income for taxpayers with modified adjusted gross income above the threshold of $250,000 for married couples and $200,000 for single persons. If investment income pushes a taxpayer over the threshold, only the excess is subject to the surtax.

Charitable gifts are not deductible for purposes of the two new Medicare surtaxes on high income earner wages and investment income. Also, taxable income from gift annuities, charitable remainder trusts, and pooled income funds may be subject to the 3.8% Medicare surtax as investment income, which includes interest, dividends, annuities, royalties, rents, and capital gains. On the other hand, donors and beneficiaries below the income thresholds will not see Medicare tax rate increases.

We are watching for IRS guidance on how the 3.8% Medicare surtax will be applied to undistributed net investment income from charitable lead trusts and remainder trusts. The Medicare surtax threshold for trusts is set to trust adjusted gross income of $11,650 (subject to indexing).

The effect of these changes on the top tax rates depends on the type of deduction or income (see table below).

Top Tax Rate 2012 Tax Law 2012 Tax Law plus Medicare Surtax Bush Sunset Bush Sunset & Medicare Surtax
Charitable deduction income tax savings 35.00% 35.00%  39.60%  39.60%
Earned income  37.90%  38.80%  42.50%  43.40%
Pension and IRA distributions  35.00%  35.00%  39.60%  39.60%
Interest, nonqualified dividends, and short term gains  35.00%  38.80%  39.60%  43.40%
Qualified dividends  15.00%  18.80%  39.60%  43.40%
Long Term Capital Gains  15.00%  18.80%  20.00%  23.80%
Estate, gift, and generation skipping transfer tax rates  35.00%  35.00%  55%*  55%*
Estate, gift, and generation skipping tax exemption amount  $5,120,000 (indexed)  $5,120,000 (indexed)  $1,000,000  $1,000,000

*55% would be the top average tax rate, but the top marginal rate is 60% for taxable estates between $10,000,000 and $17,184,000 to eliminate the benefit of the graduated brackets for smaller taxable estates.

Donors, particularly those in the top tax brackets, will face some planning choices as 2012 closes.

  • Sell capital gain assets in 2012 rather than wait until 2013 in order to lock in the low 15% long term capital gains tax rate. For example, selling appreciated property with $100,000 in long term capital gain in 2012 could save $8,800 over waiting until 2013. Bargain sales may be a good option for donors wishing to unload certain properties.
  • Delay charitable gifts from 2012 into 2013 in order to benefit from tax savings at a 39.6% tax rate rather than 35%. For example, on a $100,000 outright gift, that would be additional tax savings of $4,600.  But tax-conscious donors nervous about market values may be better off making a life income gift in 2012 than waiting to give in 2013.
  • Make taxable gifts in 2012 to lock in the $5,120,000 exemption and avoid the lower gift and estate tax exemption amounts scheduled to return in 2013. We could see a rush to complete lead trust gifts in November and December 2012.

What about after December 31, 2012? Higher income tax rates increase the tax incentive for making charitable gifts. Nevertheless, the added complexities of the new Medicare surtaxes may confuse some donors, so gift planners should be ready to dispel misconceptions.

Here in July, what will actually happen to tax rates on January 1, 2013 is still very much in question, which makes planning difficult until after the November election. Republicans want to lower the top income tax rates to 28%, repeal the new Medicare surtaxes, and eliminate the estate tax. Democrats support extending the Bush tax cuts for another year for families with incomes below $250,000 and setting the estate tax exemption amount at $3,500,000 with a 45% top tax rate.

Even if nothing happens in Congress before the November elections, we could see something afterwards.


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