The crowning achievement of the Obama administration has been the 2010 Affordable Care Act, a.k.a. Obamacare. Contrary to popular opinion this government take-over of healthcare comes with several strings attached. One of the more transparent “gotchas” of the law is a 3.8 percent investment income surtax that will be applied to “high-income” earners beginning in 2013.
Who is a High-Income Earner?
The 3.8 surtax will be applied to investment income above the following thresholds:
- Single filers making more than $200,000
- Married filers making more than $250,000
- Married (filing separately) making more than $125,000
- Trust and estates making more than $12,000 (No, that’s not a typo!)
What is and What’s Not Considered Investment Income?
Below are the common items that are considered investment income:
- Passive Rental Income
- Capital Gains (long and short-term)
- Annuity Withdrawals (but not while in tax-deferral)
- Royalty Income (rights in mineral, oil, gas, etc.)
These common items are not considered investment income:
- Wages and self-employment income
- Active Business Income
- Distributions from IRAs, Roths, etc.
- Municipal Bond Interest
- Life Insurance Proceeds
- Social Security & Veterans’ Benefits
The most important thing to be aware of is that taxable income from the above sources can push you over the income threshold and cause your investment income to be subjected to the 3.8 percent surtax.
Some may counter that these “high-income” earners can afford to pay more in taxes, but many (especially small business owners) are up in arms about yet another tax being imposed on them at quite possibly the worst time. If you’re affected, here are some prescriptions for relief from the Obamacare surtax:
Sock More Away. Max out your 401(k), 403(b), Simple IRA & SEP IRA contributions, which can help reduce your overall income. In retirement, withdrawals from these plans are not considered investment income and thus not exposed to the surtax.
Convert, Convert, Convert. There’s a bounty of reasons to convert to a tax-free Roth. Add the Obamacare surtax to the list. By paying tax on your retirement savings now, you’re removing the uncertainty of future tax rates and the mandatory requirement to begin withdrawing money when you’re age 70 ½. This dramatically lowers your future taxable income.
Give the Gift of Tax Savings. Consider taking advantage of the large lifetime gift tax exemption that is available now. The 2012 exemption is $5.12 million per person (and could fall to $1 million in 2013). Gifts can be used to pass money down to a child or even up to a parent. The gift could be used to help fund a tax-free life insurance policy or to pay the tax on a Roth conversion.
Shift Your Investment Focus. In a high-tax environment (think 2013 and beyond) tax-free and tax-deferred becomes more and more in vogue. Consider taking some gains now while rates are low and shifting your investment strategy towards assets that provide more tax-efficiency and control (examples include deferred fixed annuities, separately managed investment accounts, or using distributions from an IRA to fund life insurance.)
Take Inventory of Your Estate Plan. Trusts are harshly punished because the surtax kicks in at just $12,000 in income. If you’re leaving your IRAs or retirement accounts to a discretionary trust you must consider avoiding the trust altogether and leaving it directly to a named beneficiary. If you work with a highly-specialized attorney ask about a separate IRA Trust that can skillfully handle IRAs.
Like you, I’m not against paying my fair share, if the game is fair, and with the rules constantly changing smart investors (and advisers) should be proactive in finding ways to take advantage of the tax laws for the informed.
Robert Russell is the author of Retirement Held Hostage, CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to The Wall Street Journal, SmartMoney, & FOX Business.