Plan for New Tax on Investment Income

EDITOR'S NOTE: This article was originally published in the May 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

High-income investors, be forewarned: Starting next year, you'll be paying a new 3.8% tax on certain kinds of unearned income. The revenue from this so-called Medicare surtax will finance part of the health care overhaul signed into law in 2010. The U.S. Supreme Court's health care ruling in June upholds nearly all of the health care law, including the surtax.

Only taxpayers with modified adjusted gross incomes of $200,000 for singles and $250,000 for joint filers in 2013 will be subject to the surtax. The new levy will apply to investment income (minus deductions), such as interest, capital gains, dividends, rental income and earnings distributed from annuities. The surtax is imposed on the smaller of net investment income or the amount that AGI exceeds the thresholds. (Workers also will pay an extra 0.9% on the Medicare portion of the payroll tax on income that exceeds the thresholds.)

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Assume a married couple has $265,000 of modified adjusted gross income, which includes $40,000 of investment income, says Gil Charney, principal tax research analyst at the Tax Institute at H&R Block. Their modified AGI exceeds the surtax threshold by $15,000. "Take the lesser of the two values and multiply it by 3.8%," says Charney. "That is the Medicare surtax."

Because the $15,000 is smaller than the $40,000 in investment income, the couple will pay a 3.8% tax on $15,000, or $570. If the couple had only $1,000 of investment income, they would pay the surtax on that lesser amount -- $1,000 -- and would owe $38.

To lower the potential tax bite next year, consider accelerating into 2012 "anything that might increase investment income or AGI," says Theodore Kurlowicz, a professor of taxation at the American College, an institution for financial professionals, in Bryn Mawr, Pa. "Anything that reduces investment income or AGI, defer into 2013."

For example, you might defer a charitable gift, especially appreciated stock. You'll get a deduction, plus you'll avoid the Medicare surtax on the gain. Alternatively, if you need the profits, you could sell the appreciated stock this year and avoid the extra tax on the gain. "You don't necessarily want to sell an investment just to avoid tax, but that 3.8% tax will eat into returns," says Charney.

Consider buying tax-exempt municipal bonds, which are exempt from the surtax, says Jeffrey Grinspoon, a partner with HighTower, a financial-services company, in Vienna, Va. Grinspoon says typically his clients hold no more than 20% to 25% in municipal bonds.

Distributions from an IRA and other retirement plans are exempt from the surtax. But the income can push you over the surtax AGI thresholds. If distributions will expose you to the surtax, consider converting money from a traditional IRA to a Roth this year. Tax-free Roth distributions will not be included in your modified AGI in future years.

Big gains on a house sale can boost a surtax bill. If you've been thinking of selling, now might be the time. If the homeowner has lived in a principal residence for two of the past five years, only a capital gain above the home-sale profit exclusion would be included as income. That exclusion is $250,000 for singles and $500,000 for married couples filing jointly. But the entire profit on the sale of a second home or vacation home could be subject to the surtax.