To do so, let’s first look at what is and is not considered investment income. (While the following may not identify all areas under the new law, it does cover the majority of them.)
Investment Income: Interest, dividends, capital gains (long and short), annuities (not those in IRAs or company plans), royalty income, passive rental income, other passive activity income
NOT Investment Income: Wages and self-employment income, active trade/business income, distributions from IRAs, Roth IRAs and company plans, excluded gain from sale of a principal residence, municipal bond interest, proceeds of life insurance policies, veterans’ benefits, Social Security benefits, gains on sale of an active interest in a partnership or S corporation.
Here are five steps to help you to begin to look at how the new tax code may affect your finances and retirement planning.
1. Identify the surtax income thresholds.
Know the MAGI (modified adjusted gross income) thresholds which determine when the 3.8 percent surtax occurs. They are as follows: Married filing jointly ($250,000); individuals ($200,000); married filing separately ($125,000). Having your MAGI under these limits means none of your investment income will be subject to the 3.8 percent surtax.
2. Look at all TAXABLE income.
Taxable income from all sources can push taxpayers over the MAGI threshold, thus causing their investment income to be subject to the 3.8 percent surtax. Income tax-free Roth distributions will NOT affect MAGI, however.
3. Understand how much will be taxed.
If the 3.8 percent surtax is imposed, it will be done so on the lesser of (1) net investment income or (2) the amount of MAGI over the income threshold.
4. Know other health care tax provisions for 2013.
The 3.8 percent surtax gets the attention, but there is also a 0.9 percent Medicare tax on wages and self-employment income over the MAGI thresholds, as well as changes to deductions for medical expenses.
5. Plan your distributions carefully.
While IRA and plan distributions themselves are exempt from the surtax, taxable distributions from these accounts can push income over MAGI thresholds, thus triggering the tax on other income. Roth conversions can be a valuable tool to eliminate future taxable income, especially for taxpayers with significant investment income or a discretionary trust as their IRA beneficiary. Conversions could also push you above your thresholds in the short-term. Salary deferrals – 401(k)s for example – can reduce MAGI for the 3.8 percent surtax but NOT for the 0.9 percent additional Medicare tax.
These are just the beginning steps to understand how your income may be taxed this year and into the future. A qualified tax professional will be able to help you better understand how your own situation may have been affected.