© George Tsartsianidis | Dreamstime.com

The Supreme Court has now ruled that the increases in the Health Care Law are tax increases. As we approach 2013, and the beginning of the Health Care Law, we need to face the effects of the eye-opening changes in taxes generated by this law.

Let’s consider what some of those effects are:

•   In 2013, employers must start reporting the cost of each employee’s medical insurance on their W-2. Companies must gear up their record keeping.

•   In 2013, a new tax of 0.9% on earnings in excess of limits. The limits for all of the income tax provisions are: $125,000 on married people filing separately, $200,000 for single people, $250,000 for married couples. Earnings consist of either salary or earned income subject to self-employment tax. While this tax is primarily aimed at “salary,” it appears that it will be handled on the tax return as if it was self-employment tax.

•   In 2013, a new tax of 3.8% on investment income (dividends, interest, passive income, royalties, etc., but not retirement income) if Adjusted Gross Income exceeds the above limits. An easy example — an individual taxpayer earns $150,000 salary, $40,000 in investment income and $40,000 in capital gains, a total of $230,000. The investment income totals $80,000, but only $30,000 is subject to the 3.8% tax, the amount in excess of $200,000 (the additional tax is $1,140).

•   Starting in 2014, a tax on an individual for not buying or participating in insurance. In 2014 the tax is $95 for each adult, plus 50% for each child. A family of two adults and one child would owe a minimum of $237.50, unless exclusions applied. However, the tax is actually the greater of that or 1% of Adjusted Gross Income. While this doesn’t sound too bad, the rate rises in 2015 and again in 2016. In 2016, the rate is either 2.5% of AGI, or $695 for each adult, 50% for children. The family of three pays $1,737.50 minimum, subject again to any exclusion.

Apparently every tax return will require medical insurance information. The primary exemptions: certain religious sects, people whose insurance premiums would exceed 8% of their income, and those whose income is so low that they would not be required to file a tax return.

•   The income tax floor for claiming medical expenses on Schedule A is increased from 7.5% to 10% of AGI in 2013.

•   The Section 125 medical expense allowances that companies have been providing will be limited to $2,500 annually beginning in 2013.

•   Firms with more than 50 employees will be penalized starting in 2014 if they do not provide insurance for employees. The penalty is $40,000 plus $2,000 for each employee in excess of a 50-employee minimum.

•   Trusts are included in the 3.8% tax if their income exceeds the bottom of the top tax bracket. Most trust income comes from investments, and the top trust tax bracket begins in 2012 at $11,650; thus almost all undistributed taxable income will be subject to the 3.8% tax.

•   Medical insurance companies have their own tax burden. First, they are required, even this year, to return premiums to the extent that they have not used 80% of the gross premiums to pay claims. Second, starting in 2014, they will be required to fund a pool to support the program.

•   There are some other facets of tax changes — the above are the highlights.

Develop a Plan

So what can you do? We can start with what’s not taxable. Municipal income is not taxable and will not factor in to any of the above computations (note that certain municipal bonds are subject to AMT). The 1% tax and the 3.8% tax are not applicable to tax returns with AGI under the $125K, $200K, $250K limits. Consider transferring investments into real estate where some rental income might be sheltered by depreciation.

Converting Investments

You can convert your IRAs into Roth investments if this tax is going to materially affect you, and your required minimum distribution (RMD) is high enough to raise concern. Consider this example: you are a 73-year-old individual with income consisting of $100,000 in wages, $150,000 in RMD, and $35,000 of investment income. Your AGI is $285,000.

Your amount subject to the 3.8% tax, however, is just the $35,000 of investment income. Thus the RMD has cast you into the 3.8% tax even though it is not subject to that tax.

If you were willing to transfer to a Roth enough of the IRA to cause the RMD to drop by, let’s say, $50,000, you would no longer be subject to the 3.8% tax. It would be advisable to make the transfer in 2012, because such a transfer is always taxable as a distribution. Depending upon the size of the required transfer, the added tax in 2012 could make the transfer prohibitive. After five years, the Roth distributions are free of all tax.

A Difference for Trusts

Trusts are in a difficult position. Capital gains have historically been maintained in and taxed to the trust. But this is investment income subject to the new tax. It might be advisable to amend the trust if possible to allow the trustee to distribute gains to the beneficiaries. Of course, their tax rates need to be taken into account before such an action. The trustee might choose to take the larger capital gains in 2012 and reinvest in similar assets.