So where does that leave high-net-worth investors and the advisors who serve them? As it stands now, there are several significant new taxes and penalties that are officially part of the tax code. The one advantage that taxpayers have is that most of the tax implications don't take effect until at least 2013, and some well past then. This gives taxpayers the ability to plan for these taxes, but also allows time for the rules to change once again.
Additional Tax on Investment Income
The House reconciliation bill included an additional tax on net investment income referred to as the "Unearned Income Medicare Contribution." The tax would equal 3.8% of the lesser of net investment income, or modified adjusted gross income (AGI) in excess of $250,000 for a family ($200,000 for a single taxpayer). Modified AGI for this tax is defined as adjusted gross income increased by any net income excluded under the foreign earned income exclusion. Because this exclusion affects relatively few taxpayers, most individuals should just think of this in terms of AGI.
Net investment income for purposes of this tax includes taxable interest (but not tax-exempt interest), dividends, capital gains, annuities and rental and royalty income. Investment income earned in the course of a trade or business not defined as a passive activity would be exempt from this tax, as would distributions from qualified plans and IRAs. This tax would be effective beginning in 2013.
Additional Medicare Tax on High-Income Taxpayers
Also included in this plan is an increase in the Medicare tax. Today, the tax equals 1.45% of all wages paid to an employee. Beginning in 2013, this rate would be increased by 0.9% to 2.35% for all wages earned by a family over $250,000 ($200,000 for single taxpayers). This tax is only imposed on consumers-there is no change to the Medicare tax paid by employers on those same wages.
Because this tax is imposed on family income, it is possible that neither spouse would be subject to this based on their own income level, but their combined income would put them over the threshold. For example, if each person in a couple earns $150,000, neither would be subject to the higher Medicare tax on their own. However, because their combined income of $300,000 exceeds the $250,000 threshold, the extra $50,000 would be subject to the additional 0.9% tax.
If a taxpayer's own wages exceed the threshold, the employer is required to withhold the additional tax. However, employers aren't required to consider a spouse's income when determining the applicability of this section for their employees. This could mean that a family would be subject to the additional Medicare tax without having it withheld from their wages.
Changes to Deductions for Medical Expenses
>Qualified medical expenses are currently deductible to the extent they exceed 7.5% of the taxpayer's adjusted gross income. Under this act, that floor will be raised to 10% beginning in 2013. For 2013 through 2016, the original 7.5% floor will continue to apply if the taxpayer or their spouse is age 65 or older by the end of the year.
Changes to Health Savings Arrangements
This act makes the following changes to how Health Savings Accounts (HSAs), Archer Medical Savings Accounts (MSAs) and flexible spending arrangements are funded and used.
For 2010, there is a 10% penalty applied to HSA distributions that are not used for qualified medical expenses. For Archer MSAs, the penalty is 15%. This act increases both penalties to 20% beginning in 2011.
For employers that allow employees to defer income into a health flexible spending account, the deferrals will be limited to $2,500 in 2013. Plans that allow for larger deferrals will not be considered qualified plans. This change does not apply to health reimbursement accounts.
The definition of medical expenses has been conformed so that HSAs, MSAs and employer plans all follow the same rules. As a result, only prescribed drugs and insulin will be a qualifying medical expense for these accounts. Expenses for over-the-counter drugs will no longer be eligible for reimbursement or coverage.
Penalties for Not Purchasing Insurance Coverage
This act does not directly mandate that all individuals must purchase insurance coverage. But, beginning in 2014, penalties will be assessed that give strong incentives to individuals to do just that.
Under this act, individuals are required to maintain "minimum essential coverage." Policies that offer minimal essential coverage generally include government-sponsored programs (such as Medicare and Medicaid), group health plans offered by employers, or those purchased by individuals from within their state's market. Individuals will be subject to a penalty for every month during which they do not maintain coverage for themselves, a spouse or a dependent. The penalty will be based on a percentage of their income, with a minimum and maximum penalty amount, and will be phased in over time.
Exceptions to the penalty apply in cases of hardship or allows for transition from one plan to another. Also exempted are those claiming religious conscience exemptions, illegal aliens, members of an Indian tribe and incarcerated individuals, among others.
Tax Credits to Assist in Paying for Insurance
In order to offset the cost of insurance, the act allows for tax credits to be paid to individuals and families with income up to four times that of the poverty line (as determined by family size) beginning in 2014.
The credit is equal to the amount that insurance premiums exceed a particular percentage of the family income. The threshold ranges from 2% of income for those with income up to 133% of the poverty line; and up to 9.5% of income for those at 400% of the poverty line. No credit is available for those with income over 400% of the poverty line.
Penalties on Employers for Not Offering Coverage
As with individuals, employers are not mandated under this act to provide coverage to their employees. Yet, beginning in 2014, employers with at least 50 full-time employees will be subject to a penalty if they do not offer health coverage to their employees, or if they offer coverage that is deemed unaffordable. Employers also will be penalized if an employee certifies that they purchased health insurance from a state insurance exchange program with the help of the tax credit described above.
The penalty is equal to $2,000 annually ($166.67 per month) for each full-time employee (over a 30-employee threshold), regardless of how many workers are actually receiving the tax credit. For example, assume an employer has 100 full-time employees and does not offer them health coverage.
If even one of those workers uses the tax credit to buy coverage on their own, the employer would owe a penalty of $166.67 per month for 70 employees, or $140,000 annually.
Excise Tax on High Cost Employer-Sponsored Health Coverage
Employer-provided insurance policies whose value exceeds a maximum threshold will be subject to a 40% excise tax on the excess value beginning in 2018. The threshold is equal to $10,200 for benefits covering a single individual and $27,500 for couples or families. This value would be indexed for inflation after 2018.
The tax is to be imposed on the provider of the coverage, not the covered individual. For those who receive coverage from their employer via a policy from an insurance company, the insurance issuer will be liable for the tax. Employers that are self-insured and act as the plan administrator themselves will be liable for the excise tax.
For eligible individuals, the thresholds are increased to $11,850 and $30,950, respectively. This includes: 1) retirees age 55 or older who aren't benefiting from Medicare, and 2) participants of employer plans covering individuals in high-risk professions, such as law enforcement, firefighters, emergency medical technicians and paramedics, among others.
While none of these changes will happen overnight, advisors are encouraged to begin helping their clients create a plan today to minimize their investment income once the taxes do take effect. Converting all or part of a traditional IRA to a Roth IRA might make sense for some investors, as qualified withdrawals after retirement would be tax-free. The new rules removing the income restrictions on conversions also create a one-time tax incentive to make the conversion in 2010. Those who convert this year will be able to defer the income recognition associated with a Roth conversion over the two subsequent years (2011 and 2012).
One final thought, for clients who have maximized their contributions to Roth IRAs. Municipal bonds, which are exempt from federal taxes, may be appropriate for a portion of an investment portfolio.
But, appropriate care must be taken to determine the credit quality of investments in municipal bonds or bond funds. As their advisor, you should work with those clients to determine whether their tax situation dictates using bonds whose income is not subject to the Alternative Minimum Tax, over other types of bonds that are availablep>
Tim Steffen, CPA/PFS, CFP, is a Senior Vice President and Financial & Estate Planning Manager at Baird, an employee-owned wealth management, capital markets, private equity and asset management firm.