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The monumental new health care legislation imposes a new Medicare tax on investment income collected by high-income individuals (SBTS, May 2010). However, the new tax doesn’t kick in until 2013.   

Strategy: Plan ahead to reduce or avoid this extra tax. Conversely, if you wait a couple of years to make your moves, it may be too late.   

To recap, you must pay a 3.8% Medicare tax on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over a $250,000 threshold ($200,000 for single filers), for tax years beginning after 2012 (see box below). “Net investment income” includes interest, dividends, royalties, rents, gains from dispositions of property and income from passive activities. 

If you expect to clear the threshold in 2013, here are five long-term ideas:

1. Think about selling your home. You can exclude tax on the first $250,000 of gain from a home sale—$500,000 for joint filers—if you’ve owned and used the place as your principal residence for at least two of the five years prior to the sale. But the 3.8% Medicare tax may apply to a portion of the gain that doesn’t qualify for the exclusion (assuming your income is high enough for the taxable portion of the gain to be affected by the new tax).

If you were planning to move soon anyway, complete the home sale before 2013. For example, if a couple can sell their home for an $800,000 profit, they’ll realize a savings of at least $11,400 (3.8% of $300,000). Similarly, you might arrange to sell a vacation home by the end of 2012.

2. Increase participation in “passive” activities. Net investment income includes amounts generated by passive activities such as rental real estate. Therefore, if you own a business interest where you do not take an active role, you might get socked with the extra tax liability, starting in 2013. However, if you “materially participate” in the business, the income generally will not count as net investment income. Start taking on a management role to meet the material participation test. Note: Special rules apply to rental real estate.

3. Add munis to your portfolio. The income from municipal bonds is exempt from federal income tax. So buying munis won’t result in the extra tax on net investment income. However, if you’re late to the party, you might have to pay a higher price. Also, projected higher tax rates after 2010 are expected to further increase demand. Caveat: Consider all the economic aspects, not just taxes. 

4. Build up your 401(k) account. Distributions from a qualified retirement plan, like a 401(k) or an IRA, don’t count as net investment income. Therefore, the more you can put away in your 401(k) plan (within the tax law limits), the more you can shelter from the extra Medicare tax. At the same time, you’re setting aside more funds that can grow on a tax-deferred basis until you’re ready to retire.

5. Favor Roth IRAs. As mentioned above, IRA distributions aren’t subject to the 3.8% Medicare tax. But post-2012 distributions from a traditional IRA will increase your MAGI, which could result in a higher tax. In contrast, qualified distributions from a Roth in existence at least five years are 100% tax-free, as long as you are age 59½ or older. Also, you might convert a traditional IRA to a Roth in 2010.

Tip: Even if you don’t convert this year, consider a pre-2013 conversion to avoid increasing MAGI in a year when the Medicare tax applies.

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