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New Law Poses Tax Risks For High-Income Investors

It will take time for investors to absorb exactly what happened—and what did not happen—in the new tax law enacted to avert the “fiscal cliff.”  Under the new law, called the American Taxpayer Relief Act (ATRA), favorable tax rates on different types of investment income generally were preserved, but certain upper-income investors will face tax increases, beginning in 2013.

When you combine the ATRA changes with the new 3.8% Medicare surtax—also making its debut in 2013—you could be hit with a rate as high as 43.4% on a portion of your investment income.
Consider the following three main new tax law provisions:

1. Ordinary income.  The existing federal income tax rate structure—with rates of 10%, 15%, 25%, 28%, 33%, and 35%—continues for most taxpayers.  But ATRA adds a new top tax of 39.6% for single filers with income of more than $400,000 and joint filers with income above $450,000.  That means that a short-term capital gain on the sale of a stock you’ve owned for a year or less—a profit taxed at ordinary income rates—could trigger the 39.6% federal rate.

2. Capital gains and qualified dividends.  Under ATRA, the maximum tax rate for net long-term capital gains and qualified dividends remains 15% (0% for investors in the lowest tax bracket).  If the law hadn’t passed, the tax rate for capital gains would have soared to 20% (10% for investors in the lowest tax bracket), and dividends were scheduled to be taxed at ordinary income rates.  Despite the reprieve for most investors, however, those who exceed those same high-income thresholds—$400,000 for single filers and $450,000 for joint filers—now will pay a maximum 20% tax rate on long-term capital gains and qualified dividends.

3. Medicare surtax.  This “add-on” tax actually was included in the 2010 health care legislation—the Patient Protection and Affordable Care Act—rather than ATRA.  But it also takes effect in 2013, and it can be just as lethal to upper-income investors as some ATRA changes.  A 3.8% Medicare surtax now will apply to the lesser of “net investment income” (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount—$200,000 for single filers and $250,000 for joint filers.  These figures will not be indexed for inflation.

For this purpose, NII is defined to include interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities, and income from the trading of financial instruments or commodities.  Certain items are excluded from the NII definition, including wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a non-passive business, and distributions from qualified retirement plans and IRAs.

Now let’s see how these tax changes might affect taxes on investment income:

Example 1.  You’re a joint filer with an annual MAGI of $170,000 consisting mainly of wages.  This puts you in the regular 28% tax bracket. At the end of the year, you realize short-term capital gains of $10,000 and long-term capital gains of $40,000, for a total of $50,000 in NII.  Because you don’t exceed the threshold for ordinary income, your short-term gains still are taxed at the 28% rate.  And you don’t exceed the threshold for capital gains either, so your long-term gains are taxed at the 15% rate.  Finally, the lesserof your NII or excess MAGI is zero, so you don’t have to pay the 3.8% Medicare surtax.

Example 2.  You’re a single filer with an annual MAGI of $500,000, consisting mainly of wages.  This puts you in the new top tax bracket of 39.6%.  At the end of the year, you realize short-term capital gains of $25,000 and long-term capital gains of $75,000, for a total of $100,000 in NII.  Your short-term gains are taxed as ordinary income at the 39.6% rate.  In addition, you exceed the threshold for capital gains, so your long-term gains are taxed at the 20% rate.  Finally, the lesser of your NII or excess MAGI is $100,000, triggering a Medicare surtax of $3,800 on top of your other taxes.

Accordingly, the new tax rules could affect the rates you pay on investment income.  And while taxes alone never should determine your investment decisions, it makes sense to factor them in when you’re considering what and when to buy or sell.  Depending on your situation, you might accelerate income or capital gains into the current year to avoid higher taxes next year, or you could postpone income or gains to next year to avoid higher taxes this year.  We can work with your tax advisor to help you decide what makes sense in your situation.



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