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iShares: Calculating the Cost of New Tax Increases


While the payroll tax hike in the New Year’s deal to avoid the fiscal cliff has received a lot of attention, investors may also want to pay attention to another lesser known federal tax increase that went into effect in early January.

The little known Obamacare provision – – known colloquially as the health care surtax — imposes a new 3.8% investment income surtax on individuals with modified adjusted gross income (MAGI) above a certain threshold ($250,000 for married taxpayers filing jointly and $200,000 for individual taxpayers). For those folks, the tax specifically hits the lesser of investment income or MAGI above the threshold amount.

I’ll be the first to admit that I try not to spend too much time with the Internal Revenue Code these days as it interferes with my recovery from being a tax attorney.  That said, as a tax geek myself, and taking a cue from Daniel Morillo and Matt Tucker’s recent calculation-heavy posts, I couldn’t help but do a little math to discover how this new surtax may impact investors differently depending on the tax status of their fixed income assets.  Here’s one example I computed:

Scenario 1 – Taxable bond interest income


Let’s say you have a married couple filing jointly who has $180,000 of MAGI from non-investment sources and another $90,000 of investment income. Let’s further assume that 60% of the investment income comes from dividends (qualified , of course) and capital gains. Then let’s assume the balance of the investment income comes from taxable bond sources, specifically the iShares Intermediate Credit Bond Fund (CIU). And finally, let’s assume that the principal amount is $1,139,241 (I backed into this amount using $36,000 and CIU’s 3.16% dividend yield).

This couple would pay a total of $18,180 in tax on their investment income.  The tax would consist of 15% tax rate on $54,000 (60% of the investment income), 28% on the $36,000 of interest income and a surtax of 3.8% on $20,000 (This represents the difference between the $250,000 threshold and the couple’s $270,000 of MAGI income).  That means on an after-tax basis, the couple keeps $71,820.

Scenario 2 – Tax-exempt bond interest income


Now, let’s say that the couple’s fixed income portfolio consists of tax-advantaged municipals, specifically the iShares National AMT-Free Muni Bond Fund (MUB), rather than taxable bonds.  Considering that the interest income on munis is tax-exempt, how would the couple’s tax situation differ?

First, we need to adjust for the lower dividend yield of MUB versus CIU to determine the new interest income amount. Once you take the principal and multiply it by the distribution yield of 3.08%, instead of getting $36,000 of interest income, the couple only gets $35,088  However, because tax-exempt income doesn’t count when you compute the surtax threshold, the couple’s total income for purposes of the surtax is now only $180,000+$54,000 or $224,000, which means that now the surtax won’t apply at all.  What that means is that on an after tax basis, the couple ends up with about $80,988, rather than $71,820.

The way I computed it, in the muni scenario, the couple still pays $8,100 on the equities but they pay nothing on the fixed income.  So although the couple’s pretax income would be $89,088 rather than $90,000, on an after-tax basis, the couple keeps more.

To be sure, I computed these scenarios on a plane without a ton of research and I used a lot of short cuts and assumptions (check my math and let me know what I’m missing in the comments section below).  And everyone’s tax situation is unique, so it’s important to discuss your tax situation with your own tax professional.

Still, my rough example does show how important it is to consider the tax implications of various investment options in the post-fiscal cliff deal, post-Obamacare world.  The last time I checked , $9K is still a nice sum.  In fact, some claim you can live on even less than that.

Sue Thompson, CIMA, is the iShares Head of Registered Investment Advisor Group.