A Potentially “Taxing” New Year for Investors

With the uncertainty surrounding the election, many wonder what will happen to health-care reform and their own health insurance if the makeup of the Senate and the presidency change after the dust settles on Nov. 6.

Certainly, it’s important to understand and evaluate the ramifications of the Affordable Care Act (ACA) and the long-term prospects of the individual mandate on your family’s medical care and costs.

Yet for investors, the ACA may also affect the health of their investments.

A 3.8 percent surtax goes into effect in January that will hit investment income for those married filers with adjusted gross incomes of $250,000 or more ($200,000 for single filers).  In addition to this frequently described “Success Tax,” investors will be looking at 0.9 percent increase in the Medicare tax on wages and self-employment income if they are at or above the same $250,000 threshold.  Only those earnings above this limit will be subject to the extra 0.9 percent.

It’s all part of the health-care bill that received its stamp of approval from the Supreme Court in June. It’s been part of the bill since day one but has not received much recognition as most media coverage centered around whether the bill would be overturned.

Defining taxable investment income

Investment income is defined by most experts as the following:  dividends, capital gains, interest (except for municipal bond interest which is exempt although it may be subject to the alternative minimum tax), rents/royalties, the taxable portion of annuity payments, income from the sale of a primary home above the current $250,000/$500,000 exclusion, the net gain from the sale of second home, and passive income from investments or real estate.

It would not include:  payouts from IRAs, pension payments, Social Security income, annuities that are part of a retirement plan, life insurance proceeds, municipal bond interest, veterans’ benefits and Schedule C or Subchapter S income. It is important to note that although these are not subject to the “Success Tax,” they may push your income up and above the $250,000 limit, which would therefore make your investment income subject to the additional levy.

What can you do?

In this situation, we advise clients that it is always better to err on the safe side and plan accordingly.
Therefore:

1. If you are debating whether to sell company or inherited stock that’s been accumulating over the years, now may be the time to do it. This holds true for options as well, as exercising non-qualified stock options normally results in ordinary income (as opposed to capital gains), which could be subject to the higher rates.
 
2. Consider switching to municipal bonds from their taxable counter parts. The tax-free yields offered by municipalities are often the better choice for those even in the mid-range tax brackets and will now be even more appealing as they retain their exempt status when the additional 3.8 percent kicks in.

3. Evaluate ROTH IRA conversion options.  The IRS lifted the income limits for conversion in 2010 so anyone can convert all or part of a traditional IRA or a company sponsored 401(k). Taxes on the amount converted are due for the same calendar year but no penalty applies for those under 59 ½ and the ROTH money (plus earnings) can be withdrawn tax free down the road. (There are nuances to converting, so consult your financial or tax advisor before doing so.)

4. Consider gifting away part of an estate. With gifting and estate tax rates also in danger of reverting back to pre-2001 levels, take advantage now to help ensure heirs are not hit with an unexpectedly large tax bill. This year, you can give away as much as $5,120,000 tax free. Next year, it drops to $1 million. Seeking the advice of a trusted estate attorney is of course recommended before making any final decisions. Fragasso Financial Advisors has outlined several strategies for you to consider to effectively pass your assets to your family in the most tax-efficient way. Click here to find out how to maximize your estate planning!

Please be sure to ask us or your CPA for more details on all potential 2013 tax changes and how to plan appropriately to help avoid them as much as possible.

After all, any headache you have on Jan. 1, 2013, should not be a result of an unexpected new tax burden!

Karen Lapina, AIF® 

Financial Advisor

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