Health Care Reform's Tax Implications

    by AAII Staff

    The recently passed health care reform bill levies new taxes that are intended to help offset the cost of expanded access to care.

    Taxpayers who have significant unearned income and those who have significant income from various sources can very well be looking at—aside from income tax changes—an additional 4.7% of tax. That’s a hefty bite.

    The most significant impacts I have seen at this point are for married couples whose modified adjusted gross income MAGI exceeds $250,000 and individuals whose incomes exceed $200,000. Taxpayers above these thresholds will pay a higher tax on dividends and interest and other types of income that are not wage income. The capital gains tax will be higher as well. As a result, I think this will impact individuals who have significant portfolios.

    Before providing detail on the new taxes, I want to state that there still remains a high amount of uncertainty about how the law is going to impact final tax regulations. Even though the bill was debated for a long time, it was rushed through. As a result, the government is going to revisit a number of issues related to the legislation, and it is difficult to predict what kinds of changes are going to be incorporated into the tax regulations.

    New Unearned Income Tax

    Starting on January 1, 2013, married couples whose incomes are above $250,000 will be assessed an additional 3.8% federal tax. The threshold for married couples filing separately would be $125,000 per person. Unmarried individuals filing as single or head of household will face a threshold of $200,000. To reiterate, this is a new, additional tax. The 3.8% levy will be on the lesser of the individual’s MAGI above those threshold amounts or their unearned income.

    For example, assume a married couple had $300,000 worth of MAGI, $75,000 of which was unearned income consisting of dividends and interest. The couple calculates how much of their MAGI is above the $250,000 threshold, which is $50,000. Therefore, only $50,000 would be subject to the 3.8% tax because it is a ‘lesser of’ calculation. (The $50,000 of MAGI is less than the passive income of $75,000.)

    Since this is a separate and complete tax, my understanding at this point is that the new tax will have no impact whatsoever on the alternative minimum tax (AMT), although we will have to wait to see how the IRS forms are prepared. My suspicion is that the tax will be over and above the AMT that a taxpayer might find themselves owing.

    Irrevocable trusts are subject to the new tax above the threshold amounts. (Living trusts are separate because they do not file their own returns; instead the creators file those returns as individuals.)

    Rental income is also subject to the additional 3.8% tax. The actual amount subject to the tax would be net rentals, which is rentals reduced by any business expenses.

    An Additional Tax

    There will be another new tax levied as of January 1, 2013. This tax is 0.9% on salaries and wages that exceed $250,000 for married couples filing jointly, $125,000 for married individuals filing separately, and $200,000 for unmarried individuals. This is an additional tax, over and above the 3.8%, and it is strictly based upon amounts of salary that you have. This is going to be an additional Medicare tax in a sense, but it will not be assessed on the employer. Rather, it will only be assessed on and withheld from the employee.

    Unlike Social Security, where there is a certain income limit at which one stops being taxed, Medicare taxes continue to be taxed on earned wages, regardless of the income level. The new law says that the extra Medicare tax is going to be assessed on couples whose wages exceed $250,000 and individuals who earn over $200,000. To be perfectly clear, this is on top of paying extra Medicare premiums for those already covered by Medicare because these high wage earners are getting paid more money too.

    Retirees and Deferred Accounts

    Distributions from deferred accounts—whether they are pensions, traditional IRAs, or defined-contribution plans—do not enter into the calculation for the 0.9% tax because it is only assessed on earned income. I did read that in the calculation of modified adjusted gross income (MAGI) the amounts distributed from deferred accounts were not included.

    The distributions from deferred accounts—whether they are pensions, traditional IRAs, defined-contribution plans or 401(k)s—do not enter into the calculation for 3.8% tax either, which is based on modified adjusted gross income. As a result, required minimum distributions (RMDs) will not push a taxpayer above the threshold for the additional tax.

    There is nothing else that I came across that I thought might be earth-shattering in particular to retired investors or those approaching retirement. However, the one thing that could hit taxpayers big is realizing capital gains, because they would be included in the calculation of unearned income. The thresholds factor in dividends, annuity income, royalties, and rents gained from disposition of property. These would all be considered a type of passive income that would be subject to the new taxes.

    IRS Regulations Forthcoming?

    It is not uncommon in complicated areas of the tax law for the Internal Revenue Service to issue regulations as to how the laws are applied. In highly complex areas, sometimes it can be years before the IRS actually comes out with definitive regulations on application.

    There have been times when the IRS issued regulations that are temporary for four, five or six years until they finalize them, and even then sometimes the final regulations are different from the temporary regulations. There are a lot of gray areas in the tax law and a lot of uncertainties, and sometimes taxpayers just have to make informed decisions as to how to proceed and evaluate their risk tolerance to certain treatments in the event that the treatment is not exactly as the IRS says it should be.

    In other words, with complex issues questions always come up that were never anticipated by the drafters of the legislation. What we typically see are “technical corrections” to tax laws. When something not intended results, the language is changed so that application of the law is as Congress intended it.

    In this case, we are dealing with the fact that the President has stated and Congress has indicated an intent to revise the law. So there’s a lot of uncertainty.

    Impact on Portfolio Decisions

    When the Bush tax cuts were enacted several years ago, the dividend tax came down to 15% and the tax on long-term capital gains was reduced to 15%. These cuts prompted a lot of investors to more readily realize their capital gains because the tax bite for doing so was not so onerous. They also started buying dividend-paying stocks and moved out of such things as certificates of deposit or bonds where the interest was taxable at their highest incremental tax rate. So I would suspect that informed elders and informed retirees are not going to just sit and take the bite. They are going to reposition their portfolios in such a way as to minimize their tax burden.

    For example, as I understand the tax law at this point in time, municipal bond interest will not be subject to the higher tax rates. Therefore, we are likely to see individuals moving from dividend-paying stocks and from other interest-bearing types of investments into municipal bonds because they will not—at least at the current time with the current legislation—be impacted by the higher tax rate.

    Tax Legislation in Question

    Outside of the health care reform bill, investors also have to contend with the expiration of the Bush tax cuts. If there are not any changes to the tax laws, beginning in 2011 we will go to back to the old laws from the start of last decade.

    Due to the inherent unpredictability of Congress, I have found that it is very difficult to do tax planning ahead more than a couple of years.

    Tax laws change because so much of taxation deals with issues having to do with social problems and other non-economic reasons. Therefore, I would caution against making irrevocable decisions purely on the tax issues because taxpayers could find that two years later there’s a new administration, things change and all of the sudden there is an entirely different tax environment.

    I always caution people to think about taxes when making decisions, but not to let taxes be the tail that wags the dog. Rushing to realize capital gains might not be the right thing. Though I’ve illustrated some issues related to the health care bill, these issues are not cast in stone. Tax issues are always evolving over time.

    Health Care Reform's New Taxes

    The health care reform law will enact two new taxes on January 1, 2013:

    • An additional 3.8% tax: Assessed on couples with modified adjusted gross incomes above $250,000 and unmarried individuals with incomes above $200,000. The 3.8% levy will be the lesser of the individual’s modified adjusted gross income above the threshold amounts and their unearned income.
    • An additional 0.9% tax: Assessed on couples with wages above $250,000 and unmarried individuals with salaries above $200,000. This will be on top of the 3.8% tax and it is strictly based upon the amounts of salary that you have.

    Distributions From Deferred Accounts Are Exempt

    Distributions from deferred accounts—whether they are pensions, traditional IRAs, or defined-contribution plans—do not enter into the calculations for either the new 3.8% tax or the new 0.9% tax.