Tax Planning for the US Supreme Court's Health Care Decision

How will health care reform be paid? It will be financed in large part by tax increases on the “wealthy”.

Here is a look at some of the tax provisions in the health care law and some things to think about with respect to tax planning:

1. Unearned Income Tax: Beginning in 2013, there will be a new tax on unearned investment income for single-filing individuals with adjusted gross income (“AGIs”) over $200,000, and married couples with AGIs over $250,000. The new additional 3.8% tax will be on investment income and will include capital gains, dividends, annuities, royalties, interest (except municipal-bond interest), and rent.

2. Medicare Insurance Tax Increase: This is an increase in the Medicare hospital insurance payroll tax rate for individuals with earned incomes in excess of $200,000 for single-filing individuals, $250,000 for married couples and $125,000 for a married individual filing a separate return. In 2013, the rate will rise to 2.35% of wages from its current level of 1.45%.

What can be done to alleviate the impact of these changes? The key in 2012 will be proactive tax planning by managing the timing and character of income.

1. Conversion of ordinary income to tax-exempt income through municipal bonds is one way to reduce future taxable income. Financial advisors must ensure that any conversion is consistent with the investor’s underlying asset allocation strategy and future projected tax rates.

Anticipated higher tax rates on ordinary income, including the new 3.8% tax, reduces the after-tax yield on taxable debt - which could impact the principal market value as well as the character of the income. Please note that the 3.8% tax will also apply to the sale of a personal residence to the extent that the gain on the sale exceeds the $500,000 principal residence sale exclusion.

2. Another planning opportunity is the conversion of a traditional IRA to a ROTH IRA in 2012. Distributions from a traditional IRA or ROTH IRA are not subject to the Medicare tax; however, a distribution from a traditional IRA increases modified AGI and may cause other investment income to become subject to the tax.

If you convert to a ROTH in 2012, you pay taxes at today’s rates on the converted amount in exchange for receiving all future income from the ROTH tax-free. An analysis needs to be completed, however, to insure this make sense from a present value perspective.

3. Tax-gain harvesting, as opposed to tax-loss harvesting, is the process of turning unrealized capital gains into realized capital gains at a specific time for tax purposes. Another way to manage your future income is to explore harvesting gains in 2012 when the long-term capital gains rate is 15%, rather than the expected 23.8% in 2013. In addition, losses are more valuable in 2013 than in 2012. One should also, however, consider capital loss carry-forwards which are more valuable in 2013, the potential of step-up value at death, and other tax considerations.

4. Accelerating one-time income recognition transactions into 2012, such as a sale of a business interest or non-business real estate, should also be considered to take advantage of this year’s lower tax rates.

Disclaimers: Telemus Investment Management, LLC, Telemus Wealth Advisors, LLC, and Beacon Investment Company, LLC, registered investment advisors, are wholly-owned affiliates of Telemus Capital Partners, LLC. Telemus Investment Brokers, LLC, member FINRA and SIPC, is a wholly-owned affiliate of Telemus Capital Partners, LLC.