AS WE KNOW, the “Fiscal Cliff” debate is over for now, however many taxpayers will not survive the fallout of the legislation that was passed. Other taxes that were not part of the Fiscal Cliff debate start in 2013 under Obamacare. The President’s reelection solidifies the law— there will be no more challenges going forward stopping these healthcare taxes from going into effect. All we can do now is strategically prepare ourselves for the additional taxation. The key here is to understand what these additional taxes are and who they affect.
First of all, these new taxes are all about adjusted gross income thresholds. If you’re married filing jointly, and your AGI is above $250,000, these new taxes apply to you. If you file as an individual, and your AGI is above $200,000, you’ll pay the extra taxes. If you’re married filing separately, an AGI above $125,000 will expose you to the new taxes. If you’re above these thresholds, you’ll be faced with two new Obamacare taxes. First, a .9% additional Medicare tax on all income above the thresholds. And second, a 3.8% surtax on all investment income if your AGI is above the thresholds.
Please note that the new 3.8% surtax can also affect trusts. If you have a trust that is producing taxable income, and filing an annual tax return, that trust will be subject to the new surtax when its annual AGI exceeds $12,000.
First, let’s look at the 3.8% surtax on investment income. What is “investment income” under the new law? It includes: interest, dividends, capital gains, both long and short; non-IRA annuity income; royalty income; passive rental income; and other passive activity income.
Income that is not exposed to the new 3.8% surtax includes: wages and self-employment income; active trade and business income; distributions from IRAs, Roth IRA’s and company plans; proceeds from the sale of a principal residence, if within the exclusion; muni bond interest; veteran’s benefits; social security benefits; and gains from the sale of an active interest in a partnership or S-corporation. Even with these exceptions, you must keep in mind that taxable income from items that are not considered investment income can still push taxpayers over the AGI thresholds and cause their investment income to be subject to the new 3.8% surtax.
In addition to the 3.8% surtax, there’s also a .9% additional Medicare tax on all wages and self-employment income when the individual’s total income is above the AGI thresholds.
If you’re above the income thresholds that we’ve discussed, then you need to start planning now for these additional taxes. The most effective strategy to eliminate the 3.8% surtax and .9% Medicare tax is to reduce your AGI below the threshold limits. The most effective way to do this is through increased contributions to 401(k)s, SEPs, SIMPLEs, IRAs, 403(b)s and other qualified pre-tax retirement programs. Business owners and high-income professionals may want to consider Defined Benefit plans which in some cases allow extremely large tax-deductible contributions. The more deductible contributions people make to lower their AGI, the less exposure they will have to these new taxes.
There are other specialized strategies that may be deployed to minimize or possibly eliminate the new taxes. The key is communication and planning. I will expect to be consulting with each of you who are above the AGI thresholds.