IRS

The Net Investment Income Tax of the Affordable Care Act

IRS

At the beginning of 2013, the 3.8% Net Investment Income Tax of Obamacare went into effect. It applies to individuals, estates and trusts that have investment income above certain threshold amounts shown in the table below.

The above amounts are not indexed for inflation. In general, investment income includes interest, dividends, capital gains, rental and royalty income, and non-qualified annuities. For investors who have loss carryforwards, their value has increased because they can now offset a tax of up to 23.8% on long-term capital gains. While distributions from an IRA or 401(k) count towards meeting the threshold, they are not subject to the 3.8% tax. Interest income from municipal bonds is also exempt.

This 3.8% tax combined with the 2013 tax rate increase means that the highest federal marginal rate on short-term capital gains and non-qualified dividends and interest is 43.4%. According to bondsonline.com, the yield on a five-year AA-rated municipal bond is 1.46%. For someone who is subject to the 43.4% rate, the taxable-equivalent yield is 2.58% which is a full 1% above the five-year Treasury rate of 1.57% and 0.5% above the five-year AA corporate rate of 2.08%. Historically, municipal bonds have had lower default rates than similarly rated corporate bonds, but the problem of overextension of state and municipal finances has become increasingly apparent, especially in light of the recent bankruptcy filing for Detroit. Those of us who live in California are keenly aware of this problem, as we have seen two high-profile bankruptcies of Stockton and San Bernardino. California’s general obligation bonds are rated among the lowest of all the states, according to this comparison from California’s Public Finance Division, and the two gargantuan pension plans of CalPERS and CalSTRS face unfunded liabilities totaling $150 billion, according to this article in San Diego Union-Tribune which notes that the $150 billion may be a conservative estimate, at best.

A few years ago, we published IFA’s Concerns with Muni Bonds, and those concerns still hold today. At the end of that article, we concluded that investors who have decided that they need to own muni bonds would be best served by passively managed funds from reputable companies such as Dimensional Fund Advisors and Vanguard. IFA continues to advise investors to use taxable accounts for tax-managed equity funds and tax-deferred accounts for fixed income. More information on IFA’s approach to asset location may be found here.