Are You Ready For The 2013 Obamacare Investment Tax?

Obamacare is first and foremost a health insurance regulation, but investors would be mistaken if they believe it won't affect them if they don't invest in that sector and they already have health insurance. One of the major features of the regulation that has not been discussed much is the tax on investment income that is being levied to pay for the regulation. This tax is likely to be particularly important to retirees.

The tax I am referring to, which took effect starting January 1, 2013, is a flat 3.8% tax on "net investment income" (i.e. all income from investments) for investors with $200,000 a year in total income ($250,000 for couples). This tax is a flat tax, which is levied in addition to other taxes owed by the investor (e.g. capital gains taxes, federal income taxes, etc). So if you make $200K a year total from capital gains, dividends and coupon payments, your job salary, business profits, and all other income sources, you will be exposed to this tax. (There are select income exemptions that I discuss below.)

Now $200,000 a year in income may seem like a lot. And for many people it is - at least if they earn $200K each and every year. But this tax is likely to hit a lot more people than just that group. Most people know that stocks have returned about 9-11% annually for the last century or so. However, that average is dragged down by bad years and up by good years. As a result, there are a lot of years where the stock market averages gains of 15-20% or more.

Given that the average investor holds a stock for about 11 months and investors tend to cash out after markets have had a big run, these years of 15-20% gains in the stock market are likely to generate about that much in capital gains. What this means is that investors with total portfolio values of anywhere from perhaps $750K to $1 million are likely to face this Obamacare tax at some point in the next few years, particularly after dividend income is considered. (For example, $750K * 15% capital gains + 5% dividends + $50K salary/pension = $200K in annual income, and $5,700 in additional taxes from this Obamacare tax.)

Data from Federal Reserve studies and the IRS suggest that many retirees or upper middle class individuals nearing retirement have portfolios of this size, suggesting that they need to be very concerned with the tax.

MLPs and direct resource investments  will face less of a tax hit because part of their income should be sheltered by resource depreciation allowances, but the high level of income these stocks throw off is unlikely to be completely protected, so if possible moving them to a tax-advantaged retirement account is also wise.

Most investors with a sizable portfolio won't be able to and won't want to move all of their assets to an IRA or other tax-favored account. For these investors, timing gains and losses will be even more important than before. Investors should try and spread large gains out over multiple years (which I know is easier said than done after stocks have had a big run-up and one is nervous about a pullback), and when facing losses that are unlikely to be recouped, investors should try to sell these securities within the first year so that the losses qualify as short-term capital losses.

Finally, investors can avoid the Obamacare taxes by investing in traditional tax-exempt municipal bonds (though there has been some talk of the administration trying to reverse this exemption). The interest on these bonds is exempt from the Obamacare tax as well as federal income taxes, but investors still may owe the Obamacare tax on any capital gains from trading in munis as well as from interest on "Build America" Bonds.