Planning for Health Care Reform Surtax

To help pay for the cost of universal health care, a new federal tax will be imposed on most net investment income for those with higher incomes. Starting in 2013, higher-income taxpayers will be subject to an additional 3.80 percent tax on most net investment income. This new tax impacts taxpayers with wages or net earnings above $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately). The exceptions to the surtax are distributions from retirement accounts, including pensions, 401(k)s and IRAs, and income generated from municipal bonds.

The following types of investment income will be affected:

• Taxable interest
• Capital gains
• Dividends
• Nonqualified annuity distributions
• Royalties
• Rental Income

Please note: The sale of a home could trigger the tax, but only on the proceeds in excess of the personal residence exclusion. For qualified individuals, the exclusion protects the seller from taxes up to $250,000 of gain; for married couples filing jointly, the exclusion applies to a gain of up to $500,000.

Calculating the tax

For individuals, the 3.80 percent health care surtax is applied to the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over the applicable threshold: $200,000 (single), $250,000 (married filing jointly), and $125,000 (married filing separately).

Example: Mark and Sue Taxpayer have earnings from wages of $175,000 and investment earnings of $100,000 for a total MAGI of $275,000. According to the rule, the 3.80 percent surtax is applied to the lesser of $100,000 (net investment income) or $25,000 (excess MAGI over threshold). In Mark and Sue’s case, only $25,000 of their investment income is subject to the health care surtax. The entire $100,000 of net investment income is subject to either capital gains or ordinary income tax, depending on the nature of the income.

What can I do to plan for the health care reform surtax?

Tax-exempt municipal bonds may become more attractive. Interest generated from a municipal bond is generally exempt from federal tax and from state tax for residents living in the issuing state. Note that private activity municipal bonds, while tax-exempt from regular federal taxes, are subject to the Alternative Minimum Tax (AMT). The AMT creates a tax liability for an individual who otherwise pays little or no tax.

When considering whether tax-exempt bonds have a place in your portfolio, guard against allowing tax avoidance to result in misaligned asset allocation. The goal of asset allocation is to reduce the investor’s risk through diversification[i].  A portfolio that is too heavy with tax-exempt bonds could be exposed to additional market risk. If you purchase bonds with the goal of holding to maturity, you may gain predictable income and a return of capital. However, if liquidity prior to maturity is a concern to you, be aware that rising interest rates typically cause bond prices to fall. Investors reacting to financial headlines can engage in indiscriminate selling and cause plummeting bond prices.

Roth IRAs may be preferable to Traditional IRAs. Although distributions from IRAs and employer-sponsored retirement plans are not subject to the 3.80-percent health care tax, distributions may increase ordinary income above the high-income thresholds. This would result in other investment or earned income becoming subject to the tax. Consider converting Traditional IRAs to Roth IRAs in 2012. Paying taxes on the conversion sooner may allow future distributions to escape the tax increases later.

Harvest gains now if you expect to sell an investment in the next few years. Although it rarely makes sense to pay taxes prematurely, you have to run the numbers if you are in the highest tax brackets. For instance, if you defer selling an asset until 2013, when capital gains increase from 15 percent to 23.80 percent, you could need more than seven years to break even because of the shrinkage in assets due to the larger amount of taxes incurred.

Consider boosting retirement contributions, especially to plans that favor older, long-term employees, such as age-weighted or new comparability plans. Not only do retirement accounts grow tax-deferred until withdrawn from the plan, they are also exempt from the new 3.80-percent surtax on investment income. One way to increase retirement contributions is to pair a defined benefit pension plan with a defined contribution plan. This may allow contributions several times higher than with a 401(k) or profit-sharing retirement plan alone.

Explore tax-advantaged ways to save, such as life insurance and annuities. While distributions from these insurance products are taxed at ordinary income tax rates, the benefit of tax deferral can offset higher tax rates. Life insurance has the additional advantage of providing a death benefit substantially higher than your account value. And life insurance distributions taken as withdrawals of basis and as loans are potentially tax-free if managed properly. Remember that loans and withdrawals generally reduce the death benefit for your family, decrease guarantees, and increase the risk of a policy lapse.

Sean Gross, CFP®, AIF® | Co-Founder & CEO Sean Gross, CFP®, AIF® is the Co-Founder and CEO of Telos Wealth Management, LLC, a Registered Investment Adviser located at 656 North Miller St., Wenatchee, WA. Sean can be reached at 509-664-8844 or at Info@TelosWealth.com.

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[i] Diversification does not guarantee a profit or protect against losses in declining markets.