The jury is still out on whether or not the bush-era tax cuts will be extended into 2013. However, there are certain new taxes that will definitely impact high income earners next year: the 3.8% net investment income tax and the additional 0.9% medicare tax. What strategies can you follow to escape these new taxes?
The 3.8% investment income surtax
For the health care mandate to be economically feasible, some taxpayers will face a 3.8% investment flat tax if their adjusted gross income exceeds $200,000 ($250,000 for joint filers). For instance, an investor with $200,000 in wages and $25,000 in investment income either through capital gains (including home sales in excess of the exclusion), interest, rent, royalties or dividends, will be subject to a 3.8% tax on the $25,000, if they are a single filer.
The increased medicare tax
The 1.45% medicare tax, which has always been a flat tax and withheld from employee paychecks, will now become progressive. Taxpayers earning over $200,000 in wages or self employment income ($250,000 for joint filers) will now face a medicare tax of 2.35% as opposed to the 1.45% everyone else pays. What’s more, unlike social security taxes, medicare taxes are not deductible for the self-employed.
What can I do to avoid these new taxes?
If you have a traditional IRA and have considered converting to a Roth IRA in the past, 2012 is the year to do it. If you convert in 2012, you’re adjusted gross income may spike, but you’ll avoid potentially being subject to the new taxes that you would be if you wait until 2013 or later. It’s also important to note that distributions from Roth IRAs are not considered net investment income and aren’t subject to the surtax thresholds. In contrast, traditional IRA distributions are subject to the surtax income thresholds. Lastly, Roth IRAs aren’t subject to the required minimum distributions at 70 1/2 which is the case with traditional IRAs.
If there is ever a time to start maximizing your retirement plan accounts such as a 401K, 2013 should be the year to do it. Contributions to a 401K, individual 401K, SEP-IRA, among other accounts may reduce your adjusted gross income below the surtax thresholds. For instance, if you’re adjust gross income for the year with bonuses is going to be $215,000, you could contribute the full amount allowed or $17,000 to your 401K to stay below the $200,000 threshold for single filers.
As for investments, you may want to consider taking a second look at municipal bonds issued by fiscally sound states. The interest income from municipal bonds is not subject to federal income tax, isn’t considered net investment income, and isn’t subject to the surtax rules. In many cases it also is not subject to state income tax. And if you live in a place like New York City and buy the city’s municipal bonds, you don’t pay local tax on the interest either.
What should I do?
It’s important to consider these tax minimizing strategies in conjunction with your overall financial plan. Taxes should be a factor, but not the overall consideration when making investment decisions.
More Questions? Ask your tax questions or find a tax professional online.
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