The New Investment Tax: How can we (legally) avoid it (for as long as possible)

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With the Supreme Court’s affirmation of Obamacare, wealthier taxpayers will face higher taxes on long-term capital gains and dividends. To help fund increased health insurance coverage, the new law increases the tax on the net investment income for certain taxpayers.

For couples with an adjusted gross income (AGI) of more than $250,000 ($200,000 for single filers), tax rates on long-term capital gains and dividends will increase from the current 15% rate to 18.8% in 2013, so long as Congress extends the current tax rates on investment income. (If the Bush tax cuts are allowed to expire,  the 18.8% rate on capital gains would increase to 23.8%, while dividends could be taxed as much as 43.4% for the highest earners. We view the latter as very low likelihood, however, at least for 2013.) Also, Medicare tax will increase by 0.9% (from 1.45% to 2.35%) on wages and self-employment income above $250,000 (joint)/$200,000 (single), and unlike Social Security tax, there’s no income ceiling.

The Supreme Court didn’t give us much time to plan for the change in tax rates, and the IRS has yet to give guidance on exactly how “investment income” will be defined. We believe the tax applies to dividends, rents, royalties, taxable interest, short- and long-term capital gains, the taxable portion of annuity payments, income from the sale of a principal home above the exclusion amount, gain from the sale of a second home, and passive income from real estate. The tax will likely not apply to payouts from a regular or Roth IRA, 401(k) plans, Social Security income, annuities that are part of a retirement plan, life-insurance proceeds, or income from a business on which you pay self-employment tax.

What can you do to minimize the impact of the new taxes?

There are a few ways to respond to the upcoming tax rate changes on net investment income:

1)      Take more gains in 2012: The change doesn’t take effect until next year, so if your AGI is going to be above the $250,000/$200,000level in 2013, it may make sense to realize some gains this year to avoid the additional tax.

2)      Favor investments with a “return of capital” component: Distributions from certain types of investments, such as most master limited partnerships (MLPs) and real estate investment trusts (REITs), include a return of capital component in addition to dividends and capital gains. The latter portion of the distribution is taxed normally, but the return of capital portion is considered a partial return of your investment and is not taxable. (There is typically “recapture” of the non-taxable portion of the distributions as either long-term capital gains or ordinary income when you sell the investment.)

3)      Use your retirement plan to your advantage: Because payouts from 401(k) plans and IRAs are not affected by the new tax, it may make sense to increase the aggressiveness of your retirement accounts and offset that with decreased aggressiveness in your taxable accounts. We would expect greater capital gains over time on the more aggressive investments; keeping them under the retirement plan umbrella avoids the additional tax on these gains.