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Portfolio > Economy & Markets > Fixed Income

Preparing Clients for the Reality of PPACA’s Investment Income Tax

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When the Supreme Court upheld most of PPACA, it confirmed that the PPACA provisions proposing an additional 3.8 percent tax on investment income will shortly become effective. If the Bush-era tax cuts are allowed to expire at the end of 2012, this could push taxes on investment income close to 40 percent for investors in the top tax brackets. Though we do not yet know the fate of the low tax rates currently in effect, one thing is certain—the additional tax on investment income will be implemented in less than six months, and your high-income clients will need advice on how to reposition their investments today to minimize its effect.

Mechanics of the tax

The 3.8 percent tax on unearned income will become effective for tax years beginning in 2013 and will affect taxpayers with adjusted gross income (AGI) of more than $200,000 for single filers or $250,000 for married couples filing jointly.

This 3.8 percent will be added to the rates currently in effect, increasing the capital gains rate from 15 percent to 18.8 percent in 2013, assuming the current law is extended. However, if the Bush-era tax cuts are allowed to expire at the end of 2012, the extra 3.8 percent tax will push rates closer to 40 percent for those in the highest tax brackets.

Though the tax is deemed to be a tax on unearned investment income, in some circumstances it can apply to a portion of a taxpayers’ AGI. In calculating the tax owed, the taxpayer must first determine his net investment income for the year. If net investment income is less than the amount by which the taxpayer’s AGI exceeds the $200,000/$250,000 threshold, the tax applies to the investment income. If net investment income is greater than the difference between AGI and the threshold amount, the tax applies to the portion of AGI that exceeds the threshold.

What is net investment income?

Essentially, net investment income is income that is considered unearned—meaning income received from investments such as stocks, bonds, and mutual funds. Net investment income includes dividends and interest received through investment in these vehicles but can also apply to income derived from a trust or, in some cases, the sale of a primary residence.

To determine whether the tax applies to the sale of a primary residence, special rules apply. A single taxpayer is permitted to exclude the first $250,000 of capital gain from his or her AGI (the amount is increased to $500,000 for a married couple filing jointly). So, for example, if a married couple purchased a home for $100,000 and later sells it for $700,000, their capital gain is $600,000. The couple would then subtract the $500,000 exclusion and add the $100,000 excess to their AGI. There is no exclusion for a secondary residence.

Amounts received from Social Security, 401(k) plans, IRAs, pensions and similar retirement income are not included in net investment income, though these types of income could still increase AGI above the threshold levels.

How do you advise?

While your clients could choose to continue their current investment strategies, repositioning even a portion of a client’s portfolio could save thousands. If your client is able to pull the recognition of large gains into the 2012 tax year, he can escape the new tax on those gains while taking advantage of currently low rates.

Most clients will want to move some of their investments to minimize the effect of the tax. For example, income from municipal bonds is exempt from the tax, and because this income does not increase AGI, moving some funds into these bonds could provide a useful strategy for middle-market clients whose AGI only slightly exceeds the threshold amounts.

Clients can also shelter some income by converting traditional IRAs to Roth IRAs so that taxes can be paid at the 2012 tax rates and withdrawn tax-free in the future.


The additional 3.8 percent tax on investment income will soon be a reality for your high-income clients. Though the IRS has yet to release significant guidance on the tax, the basic structure is in place so that your clients can begin planning now for changes coming next year.

For more on the impact of PPACA, see also:

PPACA: The Court of Public Opinion

MLR Calculations to Get Even More Complicated

Q&A: 10 Things You Need to Know About the PPACA Ruling

Originally appeared on National Underwriter Advanced Markets, a LifeHealthPro partner.


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