August Tax Tips

As we have recently reported, Congress is making some major tax law changes now that will impact taxes for many years in the future.

One of the biggest changes will occur after 2012 and will involve a 3.8% Medicare tax on investment income. First, this tax will apply only to those single taxpayers who earn at least $200,000 and any married couple earning at least $250,000 ($125,000 if filing separately- just another example of a marriage penalty in our tax code). The tax also applies to estates and trusts (but not to any charitable trusts that are otherwise exempt from paying taxes).

For purposes of this new tax, “investment income” includes income from interest, dividends, annuities, capital gains, royalties and rents. For any rents and royalties, the tax would only apply to a net amount (after expenses). The tax does NOT apply to tax-exempt bond interest and gains from the sale of a principal residence (unless there is a tax due after the exclusion has been claimed). Thus, if you are planning to sell your primary residence in the next year or two and will have a taxable gain (if the gain exceeds the $250,000 or $500,000 exclusion amounts for single or married taxpayers), it would be wise to consider selling the home before 2013 so that the gains are not hit with an extra 3.8% tax. The tax savings could be huge, depending upon the extent of the overall gain that is taxable.

This same rule applies to sales of second homes or other investment real estate (not rental properties). Thus, if you are planning on selling a second or vacation home soon, it may make a lot of sense to sell before 2013 if there will be a taxable gain.

Given that tax-exempt municipal bonds are exempt from this tax, we are expecting many financial planners to be recommending these tax-favored investments when the new 3.8% tax goes into effect. Furthermore, this 3.8% tax increase will be in addition to any other tax increases in the future. We continue to expect the tax rates to increase, certainly before 2013.

For instance, we are expecting the taxes on long-term capital gains to increase from 15% to at least 20%. Beginning in 2013 for high-income taxpayers, this tax will actually be 23.8% (assuming our 20% rate prediction is correct). Thus, this new tax will certainly cause us to think about selling appreciated assets before the tax increase goes into effect.

There are a few other planning opportunities present here as well. The new tax does not apply to business income earned from a trade or business. It does not matter how the business is set up, as this will not apply to business income from a sole proprietorship, partnership, LLC or S corporation. It will apply to any business that results in passive income, so entities such as limited partnerships may be subject to this extra tax. We are awaiting additional IRS guidance on this issue.

One investment that is specifically excluded is distributions from tax-favored retirement plans, including individual retirement accounts (IRA) and qualified employer plans (such as 401(k) or 403(b) plans). This will make these plans even more advantageous than they are today.

If you are not fully funding a retirement plan at work or contributing the maximum to an IRA every year, it would be a good idea to review this plan and see if you can now fully fund these plans. If you fund a taxable account and then receive dividends or capital gains, this income would be subject to the 3.8% tax. But if you make these same exact investments in a retirement plan, these will NOT be subject to the 3.8% tax. This again leads us to favor IRAs in general and Roth IRAs in specific, as a Roth IRA will not generate any taxable income in most situations and thus the 3.8% tax will not apply to Roth IRA distributions. If you have been considering a rollover to a Roth IRA from a regular, traditional IRA, it again should be done before 2013 as this rollover will count in your overall income for purposes of the threshold for the 3.8% tax. Thus, if you are married filing jointly and your income is $250,000 (the threshold), converting an IRA to a Roth IRA would push your income over the threshold and subject some of your investment income to the extra taxes. Thus, tax planning will become even more key in the upcoming years as we work to find ways to legally avoid these new taxes.