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Preparing for the New Medicare Tax

Beginning in 2013, certain high-income individuals will become subject to a new 3.8% Medicare tax on investment income.  Even though the tax is nearly three years away, most individuals invest with a long-term horizon.  Thus, it is not too soon to reassess your strategy in light of this new tax.

How the New Medicare tax May Impact Investment Strategies
The recently enacted health reform legislation creates a new 3.8% tax on unearned income of individuals who exceed certain high income thresholds.  For a married couple, the gross income threshold is $250,000 ($200,000 for a single individual).

In a nutshell the 3.8% tax will be assessed on the lesser of net investment income or the excess of gross income over the threshold mentioned above.

Net investment income will include interest, dividends, annuities, rent & royalties and net capital gains.  This income will be reduced by deductions that are directly related to producing the income, such as depreciation and operating expenses.

With that as a background, strategies to minimize the tax might include:

Capital Gains
Sales of highly appreciated assets like a business, vacation home or art should be timed in such a way as to occur in a low-income year, or before 2013, if prudent to do so.

Tax-Exempt Income
Investment income for purposes of the new tax will not include interest from tax-exempt obligations.  As a result, the yield on these types of investments may become more attractive.  Tax-exempt income will also help keep your gross income at or below the gross income threshold. 

Retirement Savings
Adding to a 401(k) or IRA may make much more sense.  Not only does the income earned inside the account escape the new tax, but future withdrawals will not be treated as investment income.  Of course, withdrawals will increase your gross income for the threshold, so the timing and amount of withdrawals will be important.  More than ever, a Roth IRA may be the best overall vehicle.  Income earned in the Roth account avoids the new tax when it is both earned and withdrawn.

In addition to the new Medicare tax in 2013, the tax rate on capital gains is scheduled to increase from the current rate of 15% to 20% in 2011, and could go higher depending on future legislative action.  Further, the special 15% tax rate on qualified dividend income is scheduled to expire at the end of this year.  In 2011, dividends will once again be taxed as ordinary income subject to rates as high as 39.6%.

So it is none too soon for prudent investors to start looking and analyzing their portfolios in light of all these new and higher taxes.  If you have questions, we are here to consult on strategy and outcomes.


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