Perhaps the biggest tax increase begins in 2013 and has to do with the new Medicare surtax on “investment” or “unearned” income for high-income folks. The new 3.8 percent tax will be assessed on dividends, rents, bond interest, capital gains and so on. That’s in addition to the usual capital gains, federal and state taxes, the first two of which were already scheduled to increase next year.
The new tax only applies to higher-income earners, individuals who make $200,000 or more and couples who make $250,000 with net investment income.
Be aware that this could push some individuals’ tax brackets above 50 percent. In other words, some of you could be working the first six months of the year for the government.
While many of you only aspire to have to worry about this new tax, what should be interesting to a broader audience is the departure from traditional tax policy this surtax spotlights: Since the inception of Medicare, the tax has been assessed solely on wages. In 2013, that will no longer be true, and other unprecedented changes may be in the works.
What this means is that good tax planning will be more imperative than ever in allowing you to keep more of what you make.
Here are a few tips that might help you soften the impact of this new tax:
**Certain bond interest, capital gains from the sale of a personal residence and distributions from retirement accounts all are exempt from the new surtax. These exemptions will tend to make these types of investments more valuable going forward. A word of caution: Distributions from traditional retirement accounts are exempt, but the income received can still push you above the tax threshold and, therefore, cause income from other sources to be subject to this new tax.
**If structured properly, certain income distributions from cash value or permanent life insurance can be received tax-free. Also, the proceeds from the death benefit of a life insurance policy are exempt and remain tax-free, so insurance can offer greater tax benefits than before.
**Roth IRA conversions now appear to be even more valuable this year. I’ve written past articles on the subject, but distributions from Roth IRAs are exempt from all income taxes. Unlike traditional retirement accounts, distributions do not increase your total gross income or cause you to exceed the dreaded tax threshold. Furthermore, by paying the tax on a Roth IRA conversion from taxable monies, such as those in a savings account, you are essentially moving taxable money that could be subject to the surtax into a tax-free environment forever.
**Consider maximizing your 401(k) or other retirement plan contributions to minimize gross income. Contributions here could push you below the tax threshold and help you avoid the surtax. If you are a business owner, consider implementing a defined benefit pension plan, which can allow for much higher contributions.
**Tax-deferred fixed annuities have begun to regain their tax appeal. Funds inside this vehicle compound tax-deferred and avoid the new Medicare tax. And, if annuitized, a portion of each payment called the “exclusion ratio” is exempt from income taxes and the new surtax. However, it’s important to note that any other form of distribution from the gains in an annuity is subject to income taxes and the surtax. If you have any questions here, get some help and be careful.
While the saying “don’t let the tax tail wag the investment dog” is still a good general principal to invest by, taxes will become increasingly influential in our investment criteria and selection process over the next several years. It’s important to keep abreast of all the rapidly changing tax laws and to discuss your specific situation with your financial and tax adviser. I’ll try in this column to keep you up to date and informed.
Orion Melehan is a certified financial planner for LMC Financial Services in Scotts Valley. Contact him at 454-8042 or firstname.lastname@example.org.
Securities and investment advisory services offered through SagePoint Financial Inc. member FINRA/SIPC a registered investment advisor. LMC Financial Services is not affiliated with SagePoint Financial Inc. or registered as a broker/dealer.