While the U.S. Supreme Court continues to review the constitutionality of the federal health insurance mandate passed in 2010, new taxes that were also created by the law will likely remain.
Beginning in 2013, two taxes are set to take effect: a 3.8% Medicare surtax on net investment income, and an additional 0.9% Medicare payroll tax.
While it is unlikely that the Supreme Court would strike down the entire health-care law, there is a possibility that the “individual mandate” provision to purchase insurance may be ruled as unconstitutional. Since the new surtax and extra payroll tax are separate from that provision, it may be prudent for investors to prepare for these taxes in 2013 regardless of the court’s decision.
Some simplified examples of how the surtax will be calculated:
Example #1: Understanding how the income threshold works
Consider Bob, who is single with a salary of $150,000 and a long-term capital gain of $100,000. His total income exceeds $200,000, so the surtax would apply to the net investment income — in this case, capital gain — above that threshold. Assuming the capital gains tax is 20% next year, Bob would be taxed 20% on the first $50,000, and 23.8% on the remaining $50,000 of the capital gain, that is above the threshold.
Example #2: Retirement account distributions may impact the surtax.
Consider a married couple with a combined salary of $200,000, taxable IRA distributions of $50,000 and interest income of $50,000. The IRA distribution is not subject to the 3.8% surtax, but the amount will cause their overall income to exceed the $250,000 threshold for couples. This would expose their $50,000 in interest income to the new 3.8% surtax, because the other components of their income make up the $250,000 threshold for married tax filers. Assuming they are in a 36% marginal income tax bracket next year, the taxable rate on the interest income would be 39.8%.
Example #3: How are trusts affected?
Interest income within a family trust is not subject to the surtax if all of the income is being paid out to beneficiaries. The individual beneficiaries, however, may be subject to the surtax depending on their financial circumstances. If the interest income was retained by the trust, and not paid out, there is a greater chance the surtax may apply to that income, since the income threshold for trusts is siginificantly lower (top income bracket for trusts and estates in 2012 is $11,650 for example).
Additional Medicare payroll tax
At the same income thresholds, an extra payroll tax of 0.9% will take effect next year that will increase the tax to 2.35% of salary, from 1.45%.
Consider the impact on a single individual with a salary of $275,000. Since the total income exceeds the threshold, the first $200,000 would be taxed at the payroll rate of 1.45% and the remaining $75,000 above the threshold would be taxed at 2.35%.
It is also important to note for future planning purposes that neither of these tax provisions are indexed for inflation. As a result, each year, more taxpayers will be subject to the taxes.
In light of the new taxes, clients may want to consider the benefits of municipal bonds and saving inside of qualified retirement accounts. Other tax-smart strategies include accelerating income in 2012, Roth IRA conversions, and harvesting capital gains in 2012, to take advantage of the current tax schedule.
A tax reversal?
Major tax reform before a presidential election in November is unlikely, and there are numerous other tax and fiscal issues under debate such as the expiring Bush-era tax cuts.
While all bonds have risks, municipal bonds may have a higher level of credit risk as compared to government bonds and CDs.
Chris Hennessey is the Faculty Director of the Babson College School of Executive Education and member of the Putnam Investments Business Advisory Group. His opinions do not necessarily reflect those of Putnam Investments. This information is not meant to be tax and/or legal advice.