October 2010
While the bulls and the bears are back and forth in the stock market, one thing is for sure…taxes are on the rise. Between the expiration of the Bush tax cuts in 2011 and the unearned income Medicare contribution tax in 2013, the highest income tax bracket will rise by 13% for ordinary income while investment income tax rates will rise between 24% and 189%! How will these tax increases affect you and what can you do about them?
Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.
— Ronald Reagan
The debate has been raging as to whether to extend the Bush tax cuts, let them lapse or selectively extend them for those with income under $250,000. President Obama favors the latter. Congressmen, facing very tough mid-term elections, have post-poned the decision to a lame duck Congress when they return in November. The path of least resistance is to let the Bush tax cuts expire, which in effect raises taxes for everyone. But, most believe there will be a partial extension of the Bush tax cuts, limited to income under $250,000.
So what changes will we see? Certainly not just a return to the days of a 39.6% top tax rate: we must not forget that the Obama Health Care and Education Reconciliation Act of 2010 also raises tax rates.
Moreover, beginning in 2013, the "unearned income Medicare Contribution Tax" will take effect. That 3.8% rate will be in addition to any other taxes and will be assessed on the lesser of:
- Net investment income, or
- the excess of modified Adjusted Gross Income over the threshold amount.
To understand what this means, we first need to define the terms.
Net Investment Income
Net Investment Income is defined in this legislation as:
- Interest
- Dividends
- Annuity payments received (taxable portion)
- Royalties
- Rents
- Gross income derived from a passive activity
- Gross income from a business of trading financial instruments or commodities
Normal investment expenses that typically are deductible would be allowed to be netted from the above gross income to arrive at the Net Investment Income.
What is not included in Net Investment Income is:
- Income to which employment taxes were already applied, and
- Distributions from retirement plans.
Income from deferred compensation plans is not specifically addressed but most believe it will not be included.
Modified Adjusted Gross Income
This now means the Adjusted Gross Income (from the front page of your tax return) plus net income excluded under the foreign owned income exclusion.
Threshold
The threshold amount is:
- Married, filing jointly $250,000
- Married, filing separately $125,000
- Single and Head of Household $200,000
The threshold amounts are not indexed for inflation.
Calculating the tax
| Single Taxpayer | 1 | 2 | 3 | 4 | 4+ RMD |
|---|---|---|---|---|---|
| (A) Modified AGI | 300,000 | 250,000 | 225,000 | 150,000 | 220,000 |
| (B) Less Threshold | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 |
| (C) Income above threshold (A-B) | 100,000 | 50,000 | 25,000 | 0 | 20,000 |
| (D) Net Investment Income | 0 | 40,000 | 35,000 | 50,000 | 50,000 |
| Subject to 3.8% tax (lesser of C or D) | 0 | 40,000 | 25,000 | 0 | 20,000 |
The lesser of the Net Investment Income and the amount that the Modified AGI exceeds the threshold is subject to the Medicare Contribution Tax.
- While the income is above the threshold, there is no net investment income.
- All the net investment income is subject to the 3.8% tax.
- Only the net investment income above the threshold is subject to tax.
- A Modified AGI below the threshold results in no Medicare contribution tax.
However, watch out for the Medicare tax cross-over zone. In example 4, if Sam's pension ($100,000) and net investment income ($50,000) was increased by a $70,000 IRA Required Minimum Distribution (even though the RMD itself is not subject to the Medicare contribution tax) the net investment income would be pushed into the taxable zone.
Trust or Estate
The 3.8% tax may apply to irrevocable trusts and estates, but with slightly different rules. The tax would be assessed on the lesser of:
- Undistributed net investment income, or
- the excess of Modified Adjusted Gross Income over the threshold amount.
The threshold for trusts and estates is the dollar amount that falls within the highest tax bracket for the year -- $11,200 for 2010. To the extent that investment income is distributed, it would be reported on the beneficiary's tax return and subject to the Medicare Contributions Tax on the beneficiary's return at a much higher threshold than the trust. For trusts with multiple beneficiaries, income-spreading could minimize the impact of this tax.
The Medicare Contributions Tax does not apply to tax-exempt trust such as 501(c)(3) charitable trusts and charitable remainder trusts.
In the case of a Grantor trust, the tax will not apply: income will be reported on the Grantor's return, where the exposure to the Medicare Contributions Tax will be calculated and assessed, if applicable.
Tax Impact
By 2013, the highest income tax bracket will be significantly higher. Assuming the Bush tax expires, the top income tax brackets will rise by 13% for ordinary income while investment income tax rates will rise between 24% and 189%!
| Top Income Bracket | 2010 | 2011 | 2013 | % Increase |
|---|---|---|---|---|
| Ordinary Income | 39.6% | 39.6% | 39.6% | 13% |
| Long-Term Cap Gains | 15% | 20.0% | 23.8% | 59% |
| Interest, ST Cap Gains, NQ Dividends | 35% | 36.6% | 43.4% | 24% |
| Qualified Dividends | 15% | 39.6% | 43.4% | 189% |
Taxes affect behavior and there will be no exception here. Investment income will be hit hard, which reduces the return for the level of risk assumed. How will investors respond? We believe Blue Chip dividend paying stocks and interest producing corporate bonds and even CD’s won’t look so attractive. It is possible that investors will move out on the risk curve to favor small to mid size growth companies.
There may be an increased interest in tax-deferred and tax-free investment vehicles and strategies. While some of these may make sense for part of your portfolio, be sure they make sound business sense apart from the tax motive and fit into your master financial plan.
Tax Planning Advice
Working with a financial planning advisor becomes more important than ever. I am not talking about a broker who just brings you investment ideas, but someone who helps you articulate what is most important to you, analyzes your cash flow, and runs stress-tested projections to see how different planning ideas may work out (using Monte Carlo simulations). Most importantly, the advisor should proactively monitor your situation and recommend necessary adjustments.
- Strategies to mitigate or eliminate the tax:
- reducing Net Investment Income
- reducing Modified AGI
- managing the cross-over zone.
Those who will benefit most from tax planning strategies will be taxpayers approaching or exceeding the threshold ($200,000 for singles and $250,000 for married filing jointly) and those who are likely to cross over the threshold.
- Potential options for reducing Net Investment Income
- Change passive to active income, if possible
- Utilize tax-free investments
- Roth IRA's
- Roth 401k's
- Health Savings accounts
- Cash Value life insurance
- Municipal bonds
- 529 plans
- Potential options for reducing Modified AGI
- Shift timing of income by contribution to tax deferred accounts
- 401K plans
- Deferred Compensation plans
- Fixed Annuities
- Convert IRA's to Roth IRA's
- Accelerate withdrawals from IRA's in lower-income years prior to Required Minimum Distributions.
While not avoiding the Medicare Contribution Tax, shifting income from qualified dividends to long-term capital gains can lower taxes.
Conclusion
As tax rates rise with the expiration of the Bush tax cut and the coming of the Medicare Contribution Tax, the importance of tax planning increases. Those with taxable income over $250,000 (married) and $200,000 (single) and for those likely to be at that level intermittently should proactively in explore their options.
An analysis of your current investment portfolio can uncover opportunities to help maximize your total after tax returns.
Of course, the tax planning strategies you consider should make sense for your portfolio and align with your overall objectives (i.e. be sure the tax tail doesn't wag the dog). Cost benefit analysis, cash flow analysis and probability analysis (Monte Carlo simulations) are important tools to evaluate the short and long term benefits--as well as the risks of various tax strategies. Seek out a financial planning advisor who can help you evaluate strategies and opportunities that are right for you.
The hardest thing in the world to understand is the income tax.
— Albert Einstein
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. View expressed in this newsletter may not reflect the views of FSC Securities Corporation. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. FSC Securities Corporation does not offer tax or legal advice. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining value.
Investments in stocks of small and mid size companies may involve additional risks. They typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, small and midsize company stocks have experienced a greater degree of market volatility than the overall market average.
A Roth IRA distribution is qualified if you've had the account for at least five years and/or the distribution is made after you've reached age 59 1/2 made prior to age 59 1/2 may be subject to a federal income tax penalty. If converting a traditional IRA to a Roth IRA, you will owe ordinary income tax on any previously deducted traditional IRA contributions and on all earnings. Because Roth IRA conversions may not be appropriate for all investors and individual situations vary we suggest that you discuss tax issues with a qualified tax advisor.
Depending upon the municipal bond offered, alternative minimum tax and state/local taxes may apply.
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