It may have been Benjamin Franklin who said, “The only things certain in life are death and taxes,” but it was Will Rogers who twisted the quote into shape. “The difference between death and taxes,” the popular humorist remarked, “is death doesn’t get worse every time Congress meets.”
Rogers was way ahead of his time. One can only wonder what his reaction to the last two New Year’s Eve debacles of the 112th Congress might have been. Congressional brinksmanship seems to reach new heights as each year ends, resulting in confusion and misunderstandings for independent financial advisors and clients alike.
This year’s major change for higher-income taxpayers is the increase from 15% to 20% in the top rate for long-term capital gains. This would be simple enough were it not for changes that went into effect Jan. 1 of this year as part of the Medicare Surtaxes enacted in 2010 as part of the Obama healthcare reforms that could increase the total tax effect to as much as 23.8%.
The Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010 (aka Obamacare) made two different surtaxes effective for 2013 and later years. The first─on earned income─is an additional levy of 0.9% on wages above the thresholds of $250,000 for joint filers; $125,000 for married couples filing separately; and $200,000 for single filers. The tax also applies to self-employment income above the thresholds.
But it’s the second surtax that could substantially impact high net worth investors. Prior to this year, the Medicare payroll tax applied only to wages, not investment income. As of this year, the legislation extends it to certain kinds of investment income when MAGI─modified adjusted gross income─exceeds those same amounts specified in the paragraph above. While the surtax is imposed on the lesser portion of the taxpayers’ net investment income─i.e. the amount by which that investment income exceeds the thresholds─ it could jump the top rate for long-term capital gains from 20% to 23.8% for some clients.
It’s important to note that the 3.8% increase will not affect someone without investment income, nor anyone whose entire income is from investments ─ as long as that income is under the MAGI thresholds.
But it is equally important to understand the expanded legislation’s broad definition of income from investments. While it includes interest, dividends, capital gains on sales of stocks and bonds, annuities, royalties, rents and income from passive investments in an enterprise in which the taxpayer is not active, there are some crucial exceptions. Under the law, investment income does not include
- tax-exempt interest from municipal bonds or (muni) bond funds;
- withdrawals from retirement plans, such as IRAs, ROTH IRAs and 401(k)s;
- life-insurance proceeds payable at death;
- veterans’ benefits and
- income from businesses actively participated in like Subchapter S corporations.
One more caution: Although withdrawals from retirement plans may be exempt from the Medicare Surtax, except for ROTH IRAs, they are still reportable as income and therefore increase MAGI.
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