Protect yourself from a potential 289 percent tax increase on certain income
Obamacare and the soon-to-expire Bush tax laws could mean a huge tax increase for some Americans under certain circumstances – as much as a 289 percent increase on dividend income. Roth conversions may deliver some protection for investors.
On Thursday, June 28, the US Supreme Court voted 5-4 to uphold President Obama's healthcare reforms. I don't want to get embroiled in the politics of this decision. I am here to let you know how it can affect your future wealth.
Effective Jan. 1, 2013, our existing tax laws, based on the 2001 EGTRRA laws put into effect by President Bush, will be expiring. This will cause the top tax bracket to increase to 39 percent and will have a major effect on the taxation of investment income. This was bound to happen eventually; taxes never stay stagnant for long in this country. What is different about this change is that these taxes will be going even higher due to the new healthcare laws.
Congress has decided the best way to pay for the healthcare reform is by adding a 3.8 percent surtax on the top earners' net investment income. These changes could be huge for some people, especially those whose income is derived from investment earnings.
Sounds like a lot of our retirees might be hit with some surprising tax increases.
According to the IRS, we will see long-term capital gains go from a tax of 15 percent all the way up to 23.8 percent, a 60 percent increase. Interest income tax will go from 35 percent to 43.4 percent, and short term capital gains will go from 35 percent up to 43.3 percent.
However, the biggest change is in qualified dividend income. That will rise an astounding 289 percent, from 15 percent to 43.4 percent. Again this is largely due to the expiration of the Bush tax cuts, along with the additional 3.8 percent surtax.
The government loves to shroud our overall tax increases in increments that look smaller than the total. They say, "We are only instituting a 3.8 percent surtax," but this surtax could equate to as much as a 25 percent increase for people in the 15 percent bracket. Don't be fooled.
So how can you protect yourself from this? The good news first: Income from your retirement plans will not be subject to the additional surtax. However, this income can increase your MAGI (modified adjusted gross income), thereby causing your other investment income to bear the brunt of the additional taxes.
In my opinion, an effective option is to convert your IRAs into Roth IRAs. Because earnings in a Roth IRA grow tax-deferred (and distributions can be completely tax-free if certain conditions are met), a conversion now will protect future distributions from the higher taxes, while having no effect on your current MAGI.
As I always say, do not attempt this without first consulting your financial advisor and your tax professional. Converting too much of your IRA in one year can cause you to pay unnecessary taxes now. Let the professionals put a multi-year plan together to help keep your taxes lower throughout your conversion stage.
Joe Wirbick is the President of the Lancaster, PA financial services firm Sequinox. Joe specializes in retirement planning and distribution. This allows him to concentrate on developing strategies that help address the unique issues that confront retirees and those approaching retirement.
Tax advice provided for informational purposes only. Tax returns should be completed in conjunction with a qualified tax professional. Sequinox Financial and JWC/JRAG do not offer tax advice and are not affiliated. Mr. Wirbick is an Investment Advisor Representative offering advisory services through Jonathan Roberts Advisory Group, Inc. (JRAG) and securities through J.W. Cole Financial, Inc. (JWC) Member FINRA/SIPC. The opinions expressed are those of Mr. Wirbick and based on information believed to be reliable but not guaranteed and subject to change and do not necessarily reflect the position of JWC/JRAG. JWC/JRAG and Sequinox are unaffiliated independent entities.