The 3.8% surtax

Beginning in 2013, single-income earners above $200,000 in modified adjusted gross income and married above $250,000 filing a joint return will pay a 3.8% surtax on unearned income such as capital gains, dividends, interest, and rents.  Also, they will pay 0.9% more in Medicare tax if wages exceed $200,000 for single filers and $250,000 for those filing jointly.

The surtax will depend on investment income or the amount by which Adjusted Gross Income is greater than the threshold, whichever amount is smaller.

Kiplinger's provides these examples:

• Couple earns $400,000 from salary plus $50,000 in investment income.  The surtax would be 50,000*.038 = $1,900.
• Another couple earns $200,000 in salary plus $150,000 in investment income.  The surtax would be 350,000 - 250,000 = 100,000 threshold, 100,000*.038 = $3,800.

The surtax won't apply to sale of primary residence unless it exceeds the usual limits of $250,000 and $500,000 gains for single and joint owners.

Consideration of the surtax could be a tipping point for those considering a Roth conversion.

Source:  10/2012 Kiplinger's p. 11

Strategic Asset Location

Investors' Silent Business Partner

Many times there is a "missing manual" type of effect in personal finance.  For example, investors reach the point where they understand that asset allocation is the first and most important step in investing, determine that they should put 30%, say, in fixed income, but then are left hanging.  Should they buy individual bonds or exchange traded funds?  And how do they decide on different asset classes within the fixed income arena?

A similar situation exists when it comes to the location of investments among taxable, IRA, and Roth IRA accounts.  Where should stocks be held?  Where should bonds be held?  How does anticipated time of holding come into play?  How do expectations of future tax rates come into play?

These questions are addressed in this short article, "Asset Location, as Well as Allocation, Matters for Retirees" by Mark McLaughlin, to at least get do-it-yourself investors thinking about tax strategy.  This is not an easy area and is definitely not trivial.  The whole investment process is about managing risk and return over a long period of time such that the most ends up in your pockets and not your silent business partner's (Uncle Sam) pockets.  In fact, this is one area where a bit of consultation can yield/produce more dollars than the consultation costs.

Taxes,DIY Investor, Milevsky

Homework time!

All DIY Investors need to read chapter 5 of "Your Money Milestones" by Moshe A. Milevsky. Actually, the whole book is worth reading because it's well written and presents a unique look at financial planning. He believes in smoothing lifetime consumption. He tells of an exercise where he asks his students to do a mocked-up personal balance sheet. These, of course, are pathetic and done wrong because, according to Dr. Milevsky, they don't include human capital. Dr. Milevsky explains to the students that they are like an oil well with a stream of earnings forthcoming over the next 40 years years or so. This stream of earnings based on their human capital needs to be taken into account on their balance sheet.

In the tax chapter he presents a typical approach of thinking of Uncle Sam as a business partner and the need to ensure that Uncle Sam doesn't take too big a cut of earnings. He talks about an anomaly that drives economists up a wall - the preference of low income individuals to give Uncle Sam an interest free loan and receive a big tax refund in April.

The part DIY Investors need to understand has to do with mutual fund returns reported for taxable accounts. Assume we see a 10% return for the year. I quote:

"The entire 10 percent might be due to interest or dividends received, or both, even if the underlying securities themselves didn't increase in value.

Alternatively, the stocks and bonds in the fund might have increased in value without being sold, and in addition, they earned some dividends and interest.

Finally, the return might result from the investments themselves being sold for a profit.

In each of these instances the bottom line amount for the DIY Investor is going to be different. Thus, returns of actively managed funds are not always what they seem.

All of this is just further reason to prefer low turnover, low fee indexed funds.