The new tax law which went into effect on January 1st, which is actually a combination of provisions from two different tax bills – the American Taxpayer Relief Act of 2012 (ATRA) and the Health Care and Education Reconciliation Act of 2010 – penalizes individuals with certain types and amounts of income. See parts 1 and 2 of The 2013 Tax Law Schizophrenic Definition of Income published on January 7th and January 14th for a discussion of the affected income types and threshold amounts, including a summary table of same.
As pointed out in the two posts, there are now five different definitions of income affecting seven different tax areas as a result of the new legislation. What I have found interesting as a CPA retirement income planner is the fact that while only two of the seven affected tax areas are directly related to investments, these two areas have commanded the vast majority of the media's attention to date.
The two investment-related tax areas, both of which were discussed in detail in the two posts, are (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. The Medicare investment income tax affects those with modified adjusted gross income ("MAGI") in excess of $200,000 if single or $250,000 if married filing joint while long-term capital gains and qualified dividends are problematic if taxable income exceeds $400,000 if single or $450,000 if married filing joint.
The penalty for crossing these thresholds is 3.8% of the lesser of net investment income or MAGI in excess of the specified threshold amounts in the case of the new Medicare investment income tax and a 20% vs. 15% tax rate on long-term capital gains and qualified dividends. While the amount of potential additional income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.
As with all major tax law changes, and I've been through many, including the Economic Recovery Tax Act of 1981 (ERTA), the Tax Reform Act of 1986 (TRA), and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA), to name a few of the biggies, the first step in evaluating how the legislation will affect you is to prepare an income tax projection for the current and future tax years. The number of years that you choose to include in your projection depends upon a number of factors that are beyond the scope of this post. Needless to say, preparation of your projection by a CPA specializing in income taxation or by another income tax professional is recommended.
In order to determine how specific tax law changes will affect you, a baseline tax projection using prior law before the various changes took effect should be prepared. The next step is to prepare a projection under the new tax law. This will enable you to determine the total amount of your additional projected income tax liability attributable to various changes in the law. Once you know this, you can fine tune your analysis to determine the amount of additional projected income tax liability attributable to specific individual changes in the law. Your analysis should include types of income, affected tax areas, and additional income tax liability resulting from exceeding specified threshold amounts.
Assuming that your income tax projection reveals that you're projected to incur more than a nominal amount of additional income tax liability that's attributable to various types and amounts of investment income, you need to read Part 2 of this post in order to learn what to do next.