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Cut exposure to Medicare taxes

Nov 4, 2012 @ 12:01 am

By Jeff Benjamin

Navigating the Medicare-related taxes in the Affordable Care Act should begin with a large gulp of reality to accept that this is one of the components of the looming fiscal cliff that is virtually certain to kick in on Jan. 1.

This means that individuals earning more than $200,000 next year and couples earning more than $250,000 will be hit with two new taxes tied to ordinary income and investment income.

A 0.9% tax will be applied to any ordinary income over the respective thresholds.

For example, if a single filer has $300,000 in wages in 2013, $100,000 will be taxed an additional 0.9%, or $900, to help finance Medicare per President Barack Obama's health care reform law.

The health care law also introduces a 3.8% “unearned income tax,” which is applied to the lesser of net investment income or modified adjusted gross income over the threshold level, according to Michael Kitces, partner and director of research at the Pinnacle Advisory Group Inc.

The tax applies to all income above the thresholds, including dividends, capital gains, interest income and income from annuities.

For example, if an individual makes $300,000, including $50,000 from investment income, the 3.8% will be applied to the $50,000 in investment income, for a tax bill of $1,900, not to the $100,000 over the $200,000 threshold.

Likewise, if an individual's total income is $210,000, including $50,000 in investment income, the 3.8% tax would be applied only to the $10,000 over the threshold, for a tax bill of $380.

While the new taxes are relatively straightforward, Mr. Kitces and others point out that there are still plenty of ways for savvy financial advisers to help clients navigate the best course through the new tax pinch.

Under the category “avoidance strategies,” Mr. Kitces recommends to “start reducing taxable income in the first place.”

To that end, he suggests allocating assets to tax-free municipal bonds, qualified retirement savings ac-counts, college savings plans — “anything that creates an income that's not taxable for the purpose of this tax,” he said.

Financial advisers will need to be particularly deft in what Mr. Kitces described as “management-over-time strategies,” which could require careful timing of investments and distributions to prevent the income in any one year from pushing a client too far over the tax threshold.

Distributions from a traditional individual retirement account, for example, are exempt from the 3.8% investment income tax, but IRA distributions can be counted as income, which could push a client's total income into the taxable range beyond the threshold.

“My advice is, earn less money,” said Carolyn McClanahan, president of Life Planning Partners Inc.

Ms. McClanahan, who is also a practicing physician, prides herself on having read the entire health care law, a topic on which she regularly speaks at industry events.

Like a lot of advisers, she expects to be facing decisions related to when and how clients should take investment gains as the end of 2012 approaches.

“What I'm doing with clients is, I'm encouraging them to split some of the difference and take some of the gains now,” Ms. McClanahan said. “And I tell people I'm not scheduling any meetings in December, because I have a feeling I'll be doing a lot of tax planning.”

Despite some early concerns, she said that one of the areas most investors won't have to worry about under the health care law is new taxes on investment gains related to the sale of a home.

The exclusion for long-term capital gains from the sale of a primary residence allows an individual to register a profit of up to $250,000, which goes up to $500,000 for a couple.

For small-business owners with earnings beyond the threshold, Ms. McClanahan said the 0.9% income tax might be avoidable, but they will likely still be hit with the 3.8% tax.

If, for example, a small-business owner makes $400,000, he or she can reduce the taxable amount by counting $250,000 as earned income, and then take another $150,000 in the form of a distribution similar to a dividend payment, Ms. McClanahan said.

“That will help you avoid the 0.9% tax,” she said. “But it won't help you avoid the additional 3.8% tax.”

DELAYING DEDUCTIONS

Another technique advisers might consider to help clients reduce their taxable income is delaying certain deductions, such as donations to charities, until next year.

As income tax rates are expected to go up January unless Congress and the president act to extend the Bush-era tax cuts, “you will get more mileage out of the deductions at the higher tax rate than you will at the current lower rate,” said Raymond Radigan, Atlantic region managing director of trust for U.S. Bank.

And along the lines of Ms. McClanahan's “splitting the difference” recommendation, Mr. Radigan said: “One thing people might want to consider is to recognize some gains this year instead of next, when the tax on long-term gains goes up almost 60%, to 23.8%, for high earners.”

Mr. Kitces described capital gains as “by far, the most controllable aspect of this.”

“If your income is $160,000 this year, it's not a bad year to take capital gains,” he said. “You will see a lot more focus on multiyear income planning to help clients either fall below the line or shift assets from high to low years.”

jbenjamin@investmentnews.com Twitter: @jeff_benjamin

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