New Health Insurance Law Makes Tax Free Investments Look Even Better

Whatever you think of health care, it will dramatically change all our lives.   For “higher income” taxpayers that make over $200,000 ($250,000 for a joint return), there will be dramatic changes.  One of the key elements to pay for health care is the “Medicare Tax”.  Congress and President Obama are taxing those “higher income” taxpayers with a new 3.8 percent Medicare tax on all investment income: interest, dividends, royalties, rents, and capital gains.

Also for the “higher income” earners, you will pay an additional .9% on your Medicare income as a federal income tax.  Currently Medicare tax on W-2 income is 2.9% with no cap.  Now, this additional federal income tax will be paid at the time you file your federal taxes, not collected with your payroll.

Usually when the government says income they mean Adjusted Gross Income, or AGI.  There might be some important considerations.  If your income is going to be over the limit ($200,000/250,000), it makes certain investments and options look more attractive.

If you are close to the $200,000 or $250,000 income limit, your AGI will be very important.  Of course, you will want it to be under the limit not to pay the additional tax.  Do you want to want a Roth IRA with no deduction or a deductible IRA? (This is the same for a deductible 401(k) vs. a Roth 401(k).  If you are on the bubble, you should probably consider a deductible IRA or 401(k).  Being above the bubble will cost you an additional Medicare Tax of 3.8%, if you are deciding on a Roth 401(k), that decision to make a Roth 401k contribution of $16,500 will cost you an additional $600+ in the new Medicare tax.  This is just one decision to consider.

Tax planing move to consider: If you are in the upper income brackets no matter what your retirement planning situation is, be sure to max out all IRA accounts including nondeductible IRAs.  For example, I just ran into a colleague and we were talking about health care and its effects.  Even though he has a 401(k), he will contribute $5,000 for 2009 and $5,000 for 2010 to his nondeductible IRA. Now he has sheltered an additional $10,000 from the Medicare tax.

Tax free investments in retirement accounts will become more popular.  The tax advantages have been amplified for all retirement accounts.  Any additional costs, which include the new tax, will decrease future returns.  Here is an example: if you buy rental real estate in an IRA and it has income, no taxes are due.  The same rental purchased individually in your name is subject to tax plus the new 3.8% Medicare tax.  All investment income inside an IRA is exempt from the new Medicare tax.  Assume in my example that additional 3.8% is $380 paid annually.  If the investor was able to reinvest the $380 for 20 years at 7 percent, that would mean a loss of future income of $15,578.29. It all adds up.

It is not just real estate that is subject to the new tax, it is interest on notes, corporate dividends and capital gains.  All investments will be subject to the new Medicare tax.  I did not include Health Saving Accounts in my discussion but they will become a necessity for investors.  The bottom line for “higher income” earners is that it is better to save in the IRA account versus outside the account.  Remember, if you save in the retirement account and have the same returns, the ultimate distribution from your IRA will not be subject to the Medicare tax.  Final thought: figuring out how to max out your IRA needs to be a top priority.  Sometimes you cannot beat those tax free strategies…

Dave Owens, CPA, CES is the managing member of Entrust Freedom, LLC.  Entrust specializes in Self Directed IRAs and 1031 Exchanges.  Check out Dave’s new book on real estate IRAs at www.daveowens.com.  He can be reached at owens66@entrustfreedom.com or 239-333-1031.