Tax changes coming in January

The Success Tax — although not technically called this by name — is a 3.8 percent surtax going into effect on Jan. 1 that will hit investment income for those married filers with adjusted gross incomes of $250,000 or more ($200,000 for single filers).

In addition, there will be a 0.9 percent increase in the Medicare tax on wages and self-employment income if they are at or above the same $250,000 earnings threshold. Only those earnings above this limit will be the subject to the extra 0.9 percent.

It's all part of the health-care bill that finally received its stamp of approval from the Supreme Court. It's been part of the bill since day one but has not received much recognition as many had hopes of the bill being overturned.

What does this mean to you?

Without official IRS guidance, investment income is defined by most experts as the following: dividends, capital gains, interest (except for municipal bond interest, which is exempt), rents/royalties, the taxable portion of annuity payments, income from the sale of a primary home above the current $250,000/$500,000 exclusion, the net gain from the sale of second home, and passive income from investments or real estate.

It would not include payouts from IRAs, pension payments, Social Security income, annuities that are part of a retirement plan, life insurance proceeds, municipal bond interest, veterans benefits and Schedule C or Subchapter S income. Note that although these are not subject to the surtax, they may push your income above the $250,000 limit, making your investment income subject to the additional levy.

Consider that the Bush-era tax cuts are due to expire in 2013 as well. If this actually happens, all income and estate tax rates will revert back to pre-2001 levels. This could mean that the top capital gains rate would revert back to 20 percent (up from 15 percent currently) and qualified dividends could jump back up to as high at 39.6 percent. Adding the additional 3.8 percent tax on top of that, high wage earners with even a modest amount of personal investment income and some company stock options to exercise could kiss goodbye as much as 23.8 percent of any long term gains and 43.4 percent of their dividends.

What can you do now?

Without knowing the exact fate of income and estate tax rates next year (the health-care tax levy is definite), it is better to err on the safe side and plan accordingly.

• For those who have been debating whether or not to sell company or inherited stock that's been accumulating over the years, now may be the year to do it. This holds true for the options as well, as exercising non-qualified stock options normally results in ordinary income (as opposed to capital gains) which could be subject to the higher rates mentioned above.

• Consider switching to municipal bonds from their taxable counter parts. The tax-free yields offered by municipalities are often the better choice for those even in the mid-range tax brackets and will now be even more appealing as they retain their exempt status when the additional 3.8 percent kicks in.

• Evaluate ROTH IRA conversion options. The IRA lifted the income limits for conversion in 2010 so anyone can convert all or part of a traditional IRA or a company-sponsored 401(k). Taxes on the amount converted are due in the same calendar year but no penalty applies for those under 59-1/2 and the ROTH money plus earnings can be withdrawn tax-free down the road.

The converted amount does affect your AGI so by waiting until next year, one could find themselves over that $250,000 threshold where they normally would not. There are other nuances to converting that one should be made aware of so consult your financial or tax advisor before doing so.

• Consider gifting away a small or large part of an estate. With gifting and estate tax rates also in danger of reverting to pre-2001 levels, why not take advantage of this year's generous gifting amounts to help ensure heirs are not hit with an unexpected large tax bill.

This year, each one of us can give away as much as $5,120,000 tax-free. This is considered a maximum lifetime gift and, if used in full, anything left in the estate will be taxed at whatever the current estate tax rate is at the time of death. Seeking the advice of a trusted estate attorney is recommended before making any final decisions.

Ask your financial adviser or CPA for more details on the tax changes mentioned and how to plan appropriately to help avoid them as much as possible.

Thomas M. Rush is a wealth adviser with Yuma Investment Group. He can be reached at 329-1700.