Impact of Health Care Reform

In our last Insight, we provided some thoughts on income tax rates that seem likely to prevail starting in 2011, and commented on the direction of possible surcharges Congress was considering to help pay for health care reform. Well, the health care part is a little clearer now as the Patient Protection and Affordable Care Act was signed into law on March 23, 2010. The following is a brief summary—in order of the effective date—of some of the resulting tax law changes likely to impact a majority of our clients:

Effective 1/1/2011

  • The penalty tax on distributions from a Health Savings Account (HSA) or an Archer Medical Savings Account (MSA) that are not used for qualified medical expenses increases to 20% of the disbursed amount. The current tax is 10% for HSAs and 15% for Archer MSAs.

Effective 1/1/2013

  • The floor for itemized deduction for unreimbursed medical expenses increases from 7.5% of Adjusted Gross Income (AGI) to 10% of AGI for regular tax purposes. The increased floor is waived for individuals age 65 and older for the tax years 2013 through 2016. The Act does not change the 10% of AGI threshold that applies under the alternative minimum tax (AMT).
  • The Medicare Part A (hospital insurance) tax on self employed income and wages increases by .9% (from 1.45% to 2.35%) on earnings over $200,000 for individual tax payers and $250,000 for married couples filing jointly. These thresholds are not indexed for inflation.
  • A new 3.8% tax—the so-called Medicare contribution—is imposed on certain unearned income (interest, dividends, capital gains, annuities, rents, and royalties) for taxpayers with AGI over $200,000 for individual and $250,000 for married couples filing jointly. These thresholds are not indexed for inflation.
  • Contributions to a flexible spending account for medical expenses are limited to $2,500 per year, indexed for inflation.

Effective 1/1/2014

  • Individuals without qualifying health care coverage will be subject to a penalty tax phased in from 2014 to 2016. In 2014, the tax is the greater of $95 ($325 for 2015, $695 for 2016) annually per person or 1.0% (2.0% for 2015 and 2.5% for 2016) of income. The penalty for minor dependents is half the adult amount, and a family’s total penalty is generally capped at three times the adult amount for that year.

These new taxes are primarily directed at higher income taxpayers, and as noted in our last Insight, are likely the first step toward a new reality where taxpayers in the top two brackets face a future with higher tax rates on ordinary income, long-term capital gains, and qualified dividends. In particular, the Medicare contribution tax is a significant change in tax policy: for the first time ever, tax revenues from investment income are being used to finance Medicare. The table below shows the impact on marginal tax rates applied to investment income for top bracket taxpayers starting in 2012.

Meanwhile, because the Medicare Part A tax and the Medicare contribution tax on unearned income don’t begin until 2013 there is ample time to plan for them. But two of the strategies we mentioned in last quarter’s Insight will become more attractive when these taxes go into effect…if not sooner:

  • The Medicare contribution tax does not apply to municipal bond interest so the contribution tax provides further incentive to reposition fixed income investments towards municipal bonds.
  • Rising marginal income tax rates on investment income make tax-management more important.

Kacy Gott

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