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. Large stocks like (NYSE:MA), (NASDAQ:GOOG), (NYSE:PG), and many others all routinely move up or down more than 20% in a given year.
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.
However, there are some things investors can do to minimize the tax hit they face. First and foremost, investors should try and move high-yielding stocks, bonds, and mutual funds into tax-favored accounts like IRAs (see my article on IRAs here for more on using unorthodox strategies in your IRA). Investments in corporate bonds like (NYSEMKT:CIK), (JLA), and (NYSE:JDD) will all face this issue. This advice is even more true when dealing with a whole variety of REITs that pay nonqualified dividends like Anally (NYSE:NLY), American Capital Mortgage (NASDAQ:MTGE), New York Mortgage (NASDAQ:NYMT), Armour (NYSE:ARR), etc. These investments pay dividends, which are taxes at ordinary income rates and now will also face the extra 3.8% Obamacare tax.
MLPs and direct resource investments like (NYSEARCA:YMLP), (NYSE:KMP), (NYSE:BWP), (NYSE:CVRR), (NYSE:SXCP), etc. 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 as I discuss briefly here). 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. This same principle applies to trading in municipal CEFs including: (NYSE:BFZ), (NYSE:BJZ), (NYSE:MUC), (NYSE:NMO), (NYSEMKT:NMZ), (NYSE:MHN), (NYSE:BSE), (NYSE:BQH), (MJI), (NYSE:MPA), (BPS), (NYSE:NUV), (NYSE:NIO), (NYSE:NQU), (NYSE:PML), (NYSE:IQI), (NYSE:VMO), (NYSEARCA:MUB), (NYSEARCA:MUNI), etc.
Overall the Tax Can Be Summarized As Follows:
Exempt from 3.8% Tax:
Municipal Bond Interest
Life Insurance Proceeds
Social Security Income
Capital Gains at Death
Business Income Earned By Active Partners in a Partnership
Income from Sale of a House (Subject to Certain Limits)
Liable for the 3.8% Tax:
Long- and Short-Term Capital Gains
Interest from Bonds (except for Munis)
Income from Annuities, MLPs, and REITs
Disclosure: I am long NMO, NMA, NMZ, VMO, CIK, JDD, JLA, MA, GOOG, MSB, CVRR, YMLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.