A Battle Plan to Combat the Onslaught of Tax Hikes

As the Obama administration pushes for higher taxes for the affluent, physicians should be mindful of the likely onslaught and ways they can minimize damage.

Debate on proposed tax increases is expected to begin in the House of Representatives as early as this summer. However, many believe that President Obama’s signing of the “paygo law” (short for “pay as you go”) earlier this year means the scene is set for substantial increases aimed primarily at those in upper-income brackets. (The paygo law requires Congress to counteract the cost of tax cuts or any increases in entitlement spending to avoid further deficit spending.)

Onslaught of tax increases loom for high-earners

If Congress doesn’t act to the contrary, tax rates for ordinary income in the top two brackets would be 36 percent and 39.6 percent. The top tax rates for dividends would be the same as for ordinary income. And the top tax rate for capital gains would be 20 percent.

A hefty tax increase for the affluent on qualified dividends is likely -- primarily, those from stocks and stock mutual funds. This top tax rate for dividends would be the same as for ordinary income in 2011, meaning a rise from the current 15 percent to a maximum rate of 39.6 percent.

For a physician approaching retirement with an annual dividend income of $100,000, this would mean a tax increase of $24,600 a year.

Also, the capital gains rate for the affluent, now capped at 15 percent, next year would increase to 20 percent — a whopping 33 percent increase.

It gets worse. The recently-passed health care bill slaps a new Medicare payroll tax on couples with combined incomes of more than $250,000 and individuals earning more than $200,000.

Beginning in 2013, all net investment income for taxpayers above these thresholds will be hit with a 3.8 percent Medicare tax. This applies to most interest income and capital gains, but it doesn’t apply to distributions from retirement plans, such as IRAs and 401(k)s.

Currently, this tax is 2.9 percent on all wages -- with workers and their employers each paying 1.45 percent. The passage of the health care bill means that, starting in 2014, affluent individuals’ share will rise to2.35 percent of their total wages.

Avoid pain later by taking these steps right now

These looming increases make it imperative for investors to revaluate their tax strategies to minimize their exposure. The coming wave of increased taxation strikes returns spun off from passive investments. It will eat away at returns incrementally, perhaps unnoticed by busy health care professionals. Eventually, however, the damage will become significant, so the key is to act preemptively.

Accordingly, these investors should consider:

Max out retirement accounts. Now is the time to make optimal use of tax-deferred retirement accounts, such IRAs and 401(k)s. Investors holding stocks in taxable accounts should consider folding them into retirement accounts to protect returns from increasing tax rates.

In the process, investors should ensure they are taking maximum advantage of tax deferrals by holding the maximum allowable amounts in these accounts. This may mean changing payroll deductions or checking account drafts to increase contributions to maximum allowable annual figures.

Swap corporate bonds for munis. Liquidate taxable investments, such as corporate bonds and use the proceeds to purchase tax-free municipal bonds -- and, of course, hold them outside tax-deferred accounts.

Switch to tax-efficient funds. Investors may get slammed by tax distributions from actively managed mutual funds, so consider liquidating those investments now and investing the proceeds in tax-managed index funds or exchange-traded funds (ETFs), which tend to trigger low capital gains.

Time for a gut check. It’s crucial for physicians to determine if their investments are still appropriate and if they’re still on track to reach their goals. With all the recent health law changes -- particularly cuts in Medicare reimbursements -- many doctors are finding that they’re going to have to work longer (or that their investments must work harder) to reach retirement goals.

Scott Hanson, CFP, CFS, ChFC, is co-founder of Hanson McClain Advisors, Inc., (www.moneymatters.com) in Sacramento, Calif. He is also co-founder of the Hanson McClain Retirement Network, which provides marketing and operations support to advisors nationwide.