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New Tax, New Planning

At the start of next year, America’s entire tax regime is set to change, as the Bush-era tax rates shift back to their previous (higher) levels, and preferential (lower) rates on capital gains and dividends phase out. The estate tax rates will go up and the exclusion amounts will go down. Congress may intercede between now and then, but in an election year, any meaningful compromise is far from certain.

This has created an unusual level of uncertainty among financial advisors and planners. However, the recent Supreme Court ruling on the 2010 Patient Protection Affordable Care Act (sometimes colloquially referred to as “Obamacare”) has taken one uncertainty off the table. We now know that a new tax will have to be planned for as of January 1. As a way of shoring up the shaky finances of our Medicare Trust Fund, the budget reconciliation bill that was passed in conjunction with the health care reform bill will impose a 3.8% “Medicare Contribution” tax starting in tax year 2013.

What does that mean to you? For 97% of all households–individuals whose current taxable income falls below $200,000, or couples with a joint income below $250,000–the tax is irrelevant; it only applies to persons above those income thresholds. (Technically, the actual number would be a modified adjusted gross income, with any net foreign income exclusion amounts added back in.)

People whose income does exceed those thresholds will pay the 3.8% tax on the lesser of two calculations. You would first calculate your overall taxable income minus the threshold amount; the amount above this would be subject tax if it happens to be lower than the second calculation. The second amount is your net investment income–that is, how much you made, in aggregate, on taxable (but not muni bond) interest, plus dividends, distributions from annuities, royalties, net rental income (after deducting for expenses, property taxes, interest expense from debt service and property depreciation), income from passive investments like partnerships, from actively trading financial instruments and commodities, plus the gain from selling non-business property. Of course, you get to subtract out losses and expenses related to those investments.

So, for example, suppose a husband and wife completed their tax forms, and found that they had adjusted gross income of $400,000 in 2013. The first number that the 3.8% tax might be applied to is $150,000 ($400,000 – $250,000). Moving to the second test, let’s suppose that they earned interest income amounting to $40,000, and had sold some stocks for a capital gains profit of another $40,000. But they had also sold some stocks at a loss, amounting to $15,000. Their net investment income comes to $65,000. That’s obviously lower than $150,000, so that is what the couple pays the Medicare Contribution taxes on. Their MC tax comes to $2,470.

Suppose the couple only earned $265,000 in that same year. They would pay taxes on $15,000 ($265,000 – $250,000) rather than on the investment income.

You might have read that this tax will be imposed on the gains from the sale of your house, but that may not be true. If your income is above the threshold limit, you and your spouse would still have to make a profit of more than $500,000 ($250,000 for singles) on the sale of your house before the tax becomes applicable.

The investment calculation does not include payouts from a regular or Roth IRA, 401(k) plan, Social Security or veterans’ benefits, or any income from a business on which you are paying self-employment tax. It also doesn’t apply to the appreciation of your stocks or mutual funds until or unless they’re sold and gains are taken. However, IRA and qualified plan distributions DO raise your modified adjusted gross income, and this, of course, can put you over the threshold. In years when you have is little investment income, this income amount above the threshold may become the applicable tax base–so you could end up paying taxes on these amounts.

Because the amount of investment income determines, in part, your total income, this is one tax that is rich with planning possibilities. Suppose, for example, that the couple mentioned earlier, whose total taxable income would have been $265,000 if they had taken gains on stocks, decided to take fewer gains, so their total taxable income fell to $249,000? The 3.8% would no longer apply to them, even though they had other investment earnings.

Since the Supreme Court decision, advisors are talking about doing just the opposite of what we normally do: deliberately taking gains this year and deferring losses into next year, either to lower 2013 income below the income threshold or to lower 2013 investment income hit by the 3.8% tax. Others have mentioned the new attractiveness of municipal bonds, whose income isn’t affected by the Medicare Contribution tax.

A longer-term strategy is to convert IRA assets to Roth IRA assets in 2012, and pay the taxes out of outside assets. Distributions from the Roth IRA never show up in any of these 3.8% calculations, and the money paid up-front in taxes lowers the taxable income amounts in the future. As a potential bonus, the tax rates in 2012 might be lower than they would be if all the tax rates jump on January 1.

Still, it is important to remember that taxes are only one component of your total investment picture. A strategy that simply tries to lower your payments to Uncle Sam may not be the best one for your personal needs, or for building retirement income.

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