Prepare now – new 3.8% tax on investment income takes effect in 2013

A new 3.8% tax on investment income will take effect in 2013, and anyone who has significant investments or who manages a trust should be planning for it now.

The tax was included in President Obama’s health care law. In the past, many people didn’t plan for the tax because they thought the law might be struck down by the Supreme Court. But now that the Supreme Court has upheld the law, the tax will take effect as scheduled starting January 1.

The tax applies to single filers with adjusted gross income over $200,000 and married filers with adjusted gross income over $250,000. It also applies to trusts (and estates) with undistributed investment income of more than about $12,000 – so the effect could be very great on them.

For single and married taxpayers, the flat 3.8% tax applies to (1) the total amount of investment income, or (2) the amount by which adjusted gross income exceeds the $200,000 or $250,000 thresholds – whichever is less. So for instance, if a single taxpayer has $225,000 in adjusted gross income and $10,000 in investment income, the tax applies to the $10,000. But if the same taxpayer has $225,000 in adjusted gross income and $50,000 in investment income, the tax applies to $25,000 (the amount by which the taxpayer’s income exceeds the $200,000 threshold).

Although the IRS hasn’t issued regulations yet defining “investment income,” it’s likely to include dividends, capital gains, rent, royalties, interest (except from municipal bonds), taxable annuities, and passive partnership income. It probably will not include retirement plan payouts, Social Security, life insurance, or veterans’ benefits.

In general – all other things being equal – it might be wise in certain cases to accelerate capital gains and other investment income so that they are recognized in 2012 rather than 2013, so as to avoid the tax.

For 2013 and beyond, since the 3.8% tax applies to investment income above the adjusted gross income threshold, the strategies for avoiding it are likely to involve (1) reducing what has to be reported as adjusted gross income, and (2) reducing what has to be reported as investment income.

These might include:

  • Shifting investments into municipal bonds. This works both ways, since municipal bond income doesn’t count toward either adjusted gross income or investment income.
  • Giving more thought to trust distributions. If a trustee has discretion over the amount of trust distributions, it might be possible to save taxes by making larger distributions in years when the trust’s income is high and the beneficiary’s income is low, and smaller distributions in other years.
  • Converting to a Roth IRA. The key advantage of a Roth is that withdrawals are tax-free, so you can take out assets without increasing your adjustable gross income. (Of course, there are many considerations involved in Roth IRAs, and you should create one only if it makes sense within your larger financial picture.)