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How Tax-Savvy Advisors Can Tackle Obamacare Taxes

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The Patient Protection and Affordable Care Act of 2010 generated a fair amount of controversy before, during and after its passage.

While its impact is mainly felt throughout the country’s health care system, the reform package also includes a number of changes affecting financial advisors and their clients.

In terms of financial and tax issues, the act added a 0.9% Medicare surtax. The tax began in 2013 and continues into 2014, notes Chad Smith, a wealth management specialist with the broker-dealer HD Vest Financial Services in the greater Dallas area.

Clients with an adjusted gross income of $200,000 for individuals and $250,000 for couples are affected.

There’s not much planning that can be done to bring down such income levels or change the amount of the surtax, of course.

“But there are strategies that you can share with clients” around other issues in the acts, Smith said. “There really are some planning opportunities.”

These issues stem from the 3.8% additional Medicare tax on interest, dividends, capital gains, annuity income and income from other passive activities, such as income from rental properties, he explains, for those with gross income levels requiring payment of the 0.9% Medicare surtax.

“In 2014, this is likely to have more of an impact on clients and advisors, because of the rise in the market,” Smith said. “With the market increase, lots of mutual funds made end-of-year capital gains distributions, and dividends and capital gains went to investors.”

This could mean that some clients may be paying an additional 3.8% tax on top of their 15% or 20% capital gains, for instance.

“We had some shock from clients last year,” Smith explained. “And HD Vest advisors are proactively working with them to mitigate the taxes.”

It’s been over a decade since the Bush tax cuts, and advisors need to keep the tax implications of the Affordable Care Act in mind when building or tweaking portfolios, he adds.

For clients in the higher tax brackets, it may make more sense for them to invest in dividend-paying stocks in qualified plans going forward.

“You could allocation dividend-paying holdings into an IRA, and then the client might not have to pay the Medicare surtax on a year-over-year tax basis when they take out the assets in retirement,” Smith noted.

“You could compound the growth on a forward basis, and they may not pay as much on the dividends as they would if they’d held them in a non-qualified account,” he stated.

Tax Savvy

Asset positioning is more important right now, Smith emphasizes, “than probably at any other time in the past 14 years.”

“Our advisors are leading the industry with this strategy, because they are tax savvy,” he said, meaning they are required to keep their clients current on the use of tax-deferred vehicles.

Clients in high tax brackets that own taxable bonds will pay a 3.8% Medicare tax on distributed coupons paid to them.

“It could be more tax efficient to look at municipals, for instance, as non-qualified assets,” Smith explained. “Especially with low Treasury yields, tax-free vehicles may make sense.”

Another step worth looking at is how annuities and life insurance accumulate cash value. Tax-deferred annuities, for instance, can help defer taxes to retirement, when income may be lower.

“Those in lower tax brackets may not be subject to the Medicare surtaxes in their retirement years,” the specialist said, “so in nonqualified accounts, you may want to defer the gains and add an annuity.”

These strategies, he underscores, “are not meant to be blanket recommendations: It all depends on the client, on the advisor and the suitability.”

What’s Ahead?

On the horizon, Smith says, are more tax changes. They most likely won’t affect individuals – those prosposals should get tied up in political gridlock – but they should hit corporations.

“There’s a lot of momentum for corporate tax reform” that could impact S corporations, which pass through gains to other entities.

For advisors with small-business clients, such as those with fewer than 50 employees and with retirement plans serviced by FAs, this reform may entail major shifts.

Advisors should be prepared to talk with clients about changing their businesses from S to C corporations, “which would have a lot of tax and planning consequences,” Smith says.

It isn’t always easy to keep up with such potential tax scenarios, he admits, but it is “another way for advisors to add value.”

— Read more from 22 Days of Tax Planning Advice on ThinkAdvisor.