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July 20th, 2012 | Forbes

Start Planning For Higher Taxes

We know that from January 1, 2013, America’s tax regime will change, and potentially quite dramatically. We expect higher taxation, but we still don’t know the full scope of change; specifically, whether the Bush-era tax rates on earned income, dividends and capital gains will revert to their previous (higher) levels.  In what is destined to be a hectic and contentious lame duck session, Congress will presumably take up this and other thorny tax issues in the short eight weeks between the November elections and the close of 2012.

Nevertheless, the recent Supreme Court ruling on the 2010 Patient Protection Affordable Care Act (aka Obamacare) has taken one source of uncertainty off the table.  We now know that a new tax will take effect on January 1.   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. Therefore, investors should start planning.

Here’s a brief description of several of the key changes:

  • A 3.8% surtax will be levied on net investment income for individuals with adjusted gross income (AGI) above $200,000 and married couples filing jointly with AGI above $250,000.  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.  (Note, however, that the tax also applies to trusts, with a much lower threshold.)
  • A new 0.9% Medicare tax will apply on earned income above $200,000 for individuals and $250,000 for married couples filing jointly.
  • The floor beneath itemized medical expense deductions will rise from 7.5% of AGI to 10% of AGI (for people over the age of 65, this change won’t kick in until 2017).
  • Allowable contributions to health flexible spending accounts will be capped at $2,500 per year.

The ‘Medicare Contribution’

First, let’s examine “net investment income.” This is how much you earn, in aggregate, on taxable (but not municipal) bond interest, dividends, distributions from annuities, royalties, net rental income; income from passive investments like partnerships, from actively trading financial instruments and commodities, plus the gain from selling non-business property.  Of course, you are able to subtract losses and expenses related to those investments.

The net investment income calculation does notinclude 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 unrealized capital gains embedded in stockholdings or mutual funds until these are sold and gains are taken.  However, IRA and qualified retirement plan distributions and taxable portions of social security do raise your modified adjusted gross income, and this, of course, can push you over the threshold that triggers the 3.8% tax.

Now that we’ve described net investment income, let’s see how this new 3.8% tax will actually work in practice. People whose incomes exceed the thresholds ($200,000 for singles, $250,000 for married filing jointly) will need to calculate whether they owe the 3.8% tax based on the lesser of two calculations.  You first calculate your overall AGI minus the threshold amount and then determine the amount of net investment income above this that will be subject to tax using some straightforward calculations. In other words, the tax= 3.8% x the lesser of AGI minus $200,000/$250,000 or net investment income.

This formula is most easily explained by way of example.  Let’s say a husband and wife complete their tax forms and calculate that they have AGI of $400,000 in 2013, which is $150,000 over the $250,000 income threshold.  Moving to the second test, let’s suppose that they earned interest income amounting to $40,000 and had capital gains of another $40,000 from selling stocks.  But they had also sold some stocks at a loss, amounting to $15,000, so their net investment income totals $65,000 ($40,000 plus $40,000 less $15,000).  That’s obviously lower than $150,000, so that is what the 3.8% Medicare Contribution is levied on.  Their MC tax comes to $2,470 in this case.

Now suppose, in a different scenario, the same couple had only earned $265,000 in that same year, with the same amount of net investment income of $65,000.  In this case they would pay taxes on only $15,000 ($265,000 – $250,000) of their investment income, or a tax of $570.

Some 2012 tax strategies

Since the amount of net investment income determines, in part, your adjusted gross income, investors should endeavor to minimize the amount of income subject to the 3.8% tax.  For instance, instead of the usual tax-loss harvesting, investors may wish to consider deliberately taking capital gains this year and deferring losses into next year, either to lower 2013 income below the income threshold or to reduce 2013 investment income subject to the 3.8% tax (for more on tax-loss harvesting, see our research).  Suppose, for example, that the aforementioned couple accelerated some gains into 2012 and took losses in 2013 such that total taxable income that would have been $265,000 is reduced to $249,000.  The 3.8% would no longer apply to them, even though they had other investment earnings.  Investors in high tax brackets may also consider investing in municipal bonds since municipal bond income isn’t subject to the 3.8% tax.

One longer-term strategy is to convert traditional IRA assets to Roth IRA assets in 2012, and pay the taxes due on conversion from non-retirement account assets.  Distributions from the Roth IRA in the future aren’t taxable and thus will never show up in any of these 3.8% calculations, whereas future distributions from traditional IRA accounts are part of adjusted gross income, which could put you over the threshold amount.   In addition, by converting to a Roth IRA in 2012, you might benefit from tax rates in 2012 that may well be lower than they will be from January 1. Finally, if you’re considering major medical procedures—perhaps hip-replacement surgery or extensive dental work—in 2012 or 2013, this year is a better time tax-wise, since next year the threshold for itemized medical deductions will increase to 10% of AGI from 7.5%.


Higher taxes are on the way in 2013.  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. Nevertheless, now is a good time for investors to examine their portfolios and tax planning strategies to determine whether they are designed for higher taxes and, if not, whether taking action before the clock ticks down this year is in order.

As Published On: Forbes


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