Many high-net-worth individuals are not happy about how President Obama’s healthcare reform will affect their portfolios, which presents a great opportunity for advisors to reach out to these customers with strategies to help mitigate its effect, according to Tim Steffen, a financial and estate planning for Baird’s private wealth management group.
“Clients aren’t happy about the Medicare tax,” he said. “Angst over the health reform extends to this new tax that will make investors’ assets less valuable. They’re angry and frustrated about why the government is raising taxes again.”
The healthcare reform ushers in two new taxes to help cover Medicare costs. One new tax is a 0.9% hike on wages earned by couples making more than $250,000 between them and on single people earning more than $200,000.
But the most talked about tax is a 3.8% investment income tax for people making more than $250,000 per year, which would apply to investment income from dividends, capital gains, annuities and rental income.
Advisors with wealthy clients have some time to prepare their plans for this forthcoming tax hit—neither tax kicks in until 2013. Before that happens, Steffen said, advisors should consider a couple of tax-planning strategies that would minimize their clients’ exposure.
First off, municipal bonds are the only investment vehicles that won’t trigger the Medicare tax. There are inherent risks, of course. “You could be buying the next Orange County,” he said. Generally speaking, muni bonds aren’t quite so secure as Treasuries, which are considered taxable.
Advisors also have to weigh up whether those munis are the best choice for their tax-averse clients. “Don’t buy munis just to avoid the tax,” Steffen said. “You have to look at what the net after-tax income would be.”
For example, assuming a marginal tax rate of 40%, applying that to a taxable bond of 5% would mean an after-tax yield of 3%. If a muni pays more than 3% in this scenario, it’s a good buy. If the muni pays out less, the client is better off buying a taxable bond.
Another factor is munis’ likely bump in popularity over the next year. Most investors are anticipating a rise in taxes next year, which will drive demand for the tax-free munis, which will in turn drive up their price, which means their yield will go down. So the goal with a muni strategy is to buy in before the impact of higher taxes takes hold.
This, of course, means that investors will be buying munis way in advance of the Medicare tax’s introduction, which could drive up prices so they’re too high by 2012, but Steffen said that there is a presidential election and a couple of congressional elections before 2013. “A lot can happen in three years,” he said. The general rule, though, is that when taxes go up, demand for muni bonds will also go up, so “if you’re going to buy, buy before the prices go up,” i.e. this year.
Advisors have another option to help manage their clients’ Medicare exposure—qualified accounts. Distribution from qualified retirement plans is not subject to the tax, although with a significant caveat. “If those payments push you over the $250,000 mark, that could make you subject to the tax,” Steffen said.
In one example, a couple earning $200,000 and drawing $50,000 in investment income would be right at the threshold. If they decided they needed $25,000 more in income and took that money from an IRA, the qualified money itself wouldn’t be taxable but since their annual income would now be $275,000, they’d have to pay Medicare tax on that top $25,000, he said.
Roth IRAs are a far more attractive proposition—since the client has already paid taxes on the assets, the money comes out free from even Medicare tax. If Steffen’s wealthy couple had topped off their $250,000 income with $25,000 from a Roth IRA, they would not be subject to that additional 3.8% tax. “Knowing that Roth IRA assets aren’t subject to Medicare tax makes them much more attractive,” to wealthy clients, he said, although he points out that tax liability is just one piece of the puzzle when determining the strategy’s suitability.
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