Health-care reform legislation introduced a payroll tax increase and a new Medicare surtax this year. While the rise in payroll tax was automatic for taxpayers with a specific income level, the 3.8% investment surtax does not apply to all forms of income. There are several types of income that are not affected by the tax including interest income from municipal bonds, and distributions from retirement accounts like IRAs and 401(k)s.
Several planning strategies may help investors mitigate the surtax
1. Consider municipal bonds. As tax rates increase, tax-free municipal bonds may become more attractive since the tax-equivalent yield or taxpayers in higher brackets increases. The tax-equivalent yield refers to the yield an investor would require in a taxable bond investment to equal the yield of a comparable tax-free municipal bond.
Hypothetical tax-equivalent yield on muni increases in 2013*
2. Reduce taxable income. Contributing to retirement plans and IRAs, funding Flexible Spending Accounts, or contributing to a Health Savings Account, can help reduce the amount of income that is taxed.
3. Explore ways to defer income. Additional tax-favored strategies may be used to defer income, such as non-qualified annuities, charitable remainder trusts, life insurance, and installment sales.
4. Monitor transactions that create taxable events. Investors should be mindful of transactions that may increase overall income above the $200,000 ($250,000 for couples) income threshold, such as the sale of highly appreciated assets or a large Roth IRA conversion.
5. Take advantage of a Roth IRA conversion. If you are under the threshold, consider converting traditional IRA assets to a Roth IRA to create tax-free income for the future. In retirement, income from a Roth IRA does not negatively affect the calculation of your income threshold.
Investors may want to review planning strategies with a financial advisor or tax professional to understand the impact on their specific financial situation.
* The tax-equivalent yield would increase for taxpayers who have experienced a rise in their tax rate as a result of the 3.8% Medicare surtax, or if they are subject to the 3.8% surtax and fall within the highest marginal tax rate set by the legislation. The tax-equivalent yield would not change for taxpayers in the lower tax brackets, who may not typically see any type of increase in their marginal tax rate on income. Tax rates reflect the highest marginal rate and incorporate additional taxes related to the health-care reform law and higher marginal rates with expiration of tax rates at the end of 2012. Municipal bond yields are hypothetical and used for illustrative purposes only.
Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. While all bonds have risks, municipal bonds may have a higher level of credit risk as compared to government bonds and CDs.
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