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Health Care Reform Taxes Will Hit Top 1% of Households

March 23, 2010 By 5 Comments
Rich Uncle Penny Bags, aka the Monopoly Man, now has to pay Medicare taxes on dividends, interest, and real estate rental income.

Investors making more than $250,000 per year per family (or $200,000 individually) will now have to pay Medicare taxes of 3.8% on dividends, interest, and real estate rental income as part of the health care reform that passed Congress and the President signed into law today. In addition, earned income such as wages and salaries, will be subject to a 4.7% Medicare tax instead of the old 2.9%.

I don’t think there is any reasonable chance health care will be overturned as unconstitutional because it is written in such a way that you aren’t technically required to buy health insurance, you will just be subject to a special excise tax if you don’t.

A lot of very, very expensive lawyers made sure the language would stand up to a challenge.  That may seem like a small distinction but it has the effect of requiring everyone to do it through an incentive system and doesn’t actually invoke the state sovereignty issues people are discussing.

The Supreme Court has repeatedly ruled, especially in connection with social security, that Congress has the right to tax individual incomes however they see fit.  (A national sales tax, on the other hand, should fail the test.)

Basically, the whole thing is being paid for by effectively doubling the Medicare tax for high income earners and charging it on dividend and interest income.  That means that Aaron and I will begin to have to pay Medicare taxes on dividends, bond interest, and real estate rental whereas before, it was only income tax.  Unless, of course, you structure your investment through SEP plans or other comparable vehicles (which we do … feel free to insert an evil laugh here).  Nevertheless, somewhere, Mr. Monopoly is crying into his money bags.  I wrote about this on the Investing for Beginners site at About.com, a division of The New York Times.

The bottom line is that unless you have household income of between $16,700 and $21,000 per month, you probably won’t be paying for the health insurance reform.

This underscores Charlie Munger’s point that a lot of good can be done for the investor by keeping as much money as possible in tax-efficient vehicles.  Someone with $1,000,000 in a Roth IRA built up over decades of work, for example, will still collect his or her $60,000 per year in dividends and not pay taxes on it because the money stays in the account and compounds until retirement.

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  • http://backtothenest.com Jane

    But how long will it take to build up that much Roth IRA if each year you can contribute at most $5000 individually (or $10,000 if you are married)? What other tax-efficient vehicles beyond Roth IRA are there?

    • http://www.joshuakennon.com Joshua Kennon

      There are a lot. The most famous, obviously, is a 401(k) or a 403(b). Those are ones offered by employers to employees (they are almost the same, but the 403(b) is for government jobs like a school district).

      There is also the Self-Employed 401(k) for small business owners and, one of my personal favorites, the SEP-IRA, which stands for “Simplified Employee Pension Individual Retirement Account”. The limit on that one is 25% of your compensation, capping out at $50,000 saved annually, which you get to write off your taxes. But the rules are very specific so it is best to have qualified accountants help you. They take only a few hours to establish.

      To use an extreme example, if you had a married couple that owned a consulting business together and who made $500,000 annually, it would be almost EFFORTLESS to get $100,000 or more into tax-advantaged retirement accounts so they wouldn’t have to pay any money on their dividends, interest, capital gains, or even rents in some situations.

      When people really go for the gold and have a lot of assets, they can use a company such as the Equity Trust Company to establish a self-directed IRA or 401(k) and then have it buy entire apartment buildings or small businesses. As long as no debt is used, they shouldn’t have to pay a PENNY in taxes on their earnings each year. (If debt is used, you get into a complex situation called UBIT, or un-related business tax).

      Likewise, if you were self-employed and had a Roth 401(k) plan, you could contribute – if you structure the plan right – up to $49,000 per year to it (technically part of the contribution comes from you as an employee and part of it comes from you as the employer, but it is all still your money). Ten or twenty years of that is all it would take at even a mediocre rate of return.

      I mean, say a 30 year old business owner did that – saved $49,000 per year in his or her 401(k) – and earned 10%. It would only take 15 years to have $1,556,851 in the account. There would be ZERO taxes on anything that money generated. That means by the time he or she was 45 years old – still a long way away from retirement – he or she would be earning $155,685.10 in tax-free money each year. It would be a massive, huge advantage over other people who had to send almost half their money into the IRS.

      The strategy of arranging assets in different accounts by tax rules is known as “asset placement”. It can make a huge difference in the long-run.

      • http://www.joshuakennon.com Joshua Kennon

        P.S. Think of it this way. Someone with a self-directed IRA or retirement plan could spend 10 to 15 years building up as much money as possible in the account. Then, they could use the account to buy a small office building for $400,000 or so. If they earn 10% pre-tax on their money, all $40,000 – every single penny – says in their retirement plan. Zero taxes if there was no debt used.

        How long would it take you to buy a second building if your account were growing by $40,000 per year from the inside plus you kept up your regular contributions? That is why money is like a snowball rolling down a hill. The hardest part is starting and working to avoid permanent losses. Suddenly, though, by the time you were retired, you could very well own an apartment complex, office buildings, storage units, dividend paying stocks, and even private businesses within your retirement plans and have millions of dollars more than you would have all because you got to keep every penny of your earnings instead of sending it to Congress.

        This is a company – I don’t endorse them I’m just using them as an example – that specializes in setting up plans like that. It’s called The Equity Trust Company. They even explain basic concepts such as the UBIT:

        UBIT applies if ALL of the following are true:

        * Income is derived from “”trade or business”” activity (i.e., sale of goods and services).
        * Business activity is not substantially related to exempt status.
        * Business is regularly carried on by organization.

        Generally, IRA investments that can generate UBTI include limited partnerships, limited liability companies, and any investment that incurs debt financing and/or is involved in an unrelated business.

        Most passive investment income—including dividends, royalties, and rent—is exempt from UBIT. However, an investment that generates income with debt financing (e.g., purchasing real estate with a non-recourse loan in an IRA) is responsible for UBIT in direct proportion to the gain/income that’s debt financed.

  • http://backtothenest.com Jane

    Thanks for the explanation, Joshua! We do have 401K (back when I was employed) and SEP-IRA (now that I’m self-employed). Now I’m wondering if instead of the SEP-IRA I should look at something like the solo 401K that allows me to contribute more as income fluctuates. Then even if I made less, I could put more away in the solo 401K than a SEP-IRA.

  • http://backtothenest.com Jane

    P.S. Also bookmarking this page to come back later to digest your tip on self directed IRAs. I don’t think we’re there yet but it will be useful to know about this should we get there :)