By Christine Fahlund on February 13, 2013

Now that the dust has settled over what some might refer to as "fiscal cliff part 1," we can see clearly one of the most visible results: higher tax rates in 2013 on investment income and long-term capital gains for those in upper income brackets:

  • The American Taxpayer Relief Act: The maximum tax rate on dividends and long-term capital gains rises to 20% from 15% for those with taxable income above $400,000 for single filers and $450,000 for those filing jointly, and the top income tax rate for income above these levels increases from 35% to 39.6%.

    These income thresholds include dividends, interest, and capital gains and other income in addition to earned income, less exemptions, and deductions.
  • The Affordable Care Act, passed in 2010: Beginning in 2013, the act levies a new 3.8% surtax on high-income earners who have modified adjusted gross income (MAGI) in excess of $250,000 for married couples filing jointly or $200,000 for single taxpayers and who also have "net investment income," which includes dividends and capital gains as well as bond interest. The tax is imposed on the lesser of the total net investment income or the amount of MAGI in excess of the threshold amount.

    For example, assume a single investor has $270,000 total MAGI in 2013, of which $45,000 is "net investment income." The investor must pay a 3.8% surtax on the lesser of $70,000 (the amount over $200,000), or $45,000. In this case, the tax applies to the $45,000, totaling $1,710 (i.e., 3.8% x $45,000).

    The act also levies an additional 0.9% Medicare tax on earned income of employees or those with self-employment income in excess of $250,000 for married couples filing jointly or $200,000 for single taxpayers. Employers must withhold the additional tax once the wages of an employee exceed $200,000, although the employee may claim a refund if the higher threshold for married joint filers applies.

    For example, employees generally pay Medicare taxes at a 1.45% rate on all wages. However, starting in 2013, those wage earners will be required to increase their contribution rate by 0.9% to 2.35% on any wages that exceed the applicable threshold.
How to Figure Taxes Into Your Retirement Plans

As tax rates increase, investors should maintain a well-diversified portfolio but pay more attention to the types of accounts in their portfolios.

With that in mind, consider the following suggestions:

  1. Contributions to traditional retirement accounts may be especially attractive for high-income investors who may be subject to the 3.8% surtax, pretax contributions to tax-deferred accounts such as traditional 401(k) plans and Traditional individual retirement accounts (IRAs) may be able to reduce their MAGI to below the threshold. In general, the more investors can incorporate these types of accounts in retirement planning, the greater the potential for long-term, tax-deferred compounded growth. Likewise, distributions from qualified retirement plans are not included in "net investment income" and therefore are not subject to the 3.8% surtax.

    • Investors who are currently subject to the 3.8% surtax may want to take advantage of the opportunity to deduct contributions to a traditional 401(k) plan now. For example, someone over age 50 could contribute up to $23,000 to a 401(k) plan in 2013 and exclude that from taxable income.

      Assuming an investor is over age 50, married and filing a joint return with a MAGI of $300,000, including $60,000 of net investment income, he or she would pay the 3.8% tax on the $50,000 over the $250,000 threshold. But if he or she made pretax contributions of $23,000 to a 401(k) plan, it would reduce the MAGI to $277,000, making only $27,000 subject to the tax and saving the investor $874 in taxes in 2013. While it may be tempting to take advantage of such tax deductions now, contributing to a Roth 401(k) account could provide more tax flexibility in the future.
  2. Conversions from Traditional accounts to Roth accounts may be attractive if retirement plan distributions are expected to increase an investor's exposure to the 3.8% tax. The investor should consider converting some assets from a Traditional IRA to a Roth IRA (or from a traditional 401(k) account to a Roth 401(k) account) to achieve long-term tax benefits in retirement. One caveat: The conversion itself could push the investor's taxable income over the MAGI threshold in the year it is made.
  3. Contributions to Roth accounts may be especially appropriate for investors with "earned income" (i.e., wages and self-employment income) below the $200,000 and $250,000 MAGI thresholds, then Roth 401(k) accounts become even more attractive. Contributions are not tax-deductible in the years they are made, but most investors could take withdrawals income-tax-free after they have held the account for 5 years and reaches age 59½. In addition, there are no required minimum distributions after age 70½ from a Roth IRA. (They are required from a Roth 401(k) account unless those assets are rolled over to a Roth IRA.) Another advantage of Roth accounts for retirees is that qualifying distributions taken from these accounts are not included in an individual's MAGI, whereas distributions from 401(k) plans and Traditional IRAs are.

    Taking distributions from Roth accounts on a selective basis in retirement can potentially enhance an investor's flexibility and after-tax income—especially if future tax rates increase or if the investor has a year with significant unexpected expenses that otherwise would require additional withdrawals from a tax-deferred account that could push the investor into a higher tax bracket.
  4. Investors should diversify between taxable, tax-exempt, and tax-deferred accounts, just as they diversify in their investment strategies, to weather the uncertainty of tax changes. It is important to have a mix of different types of accounts to provide flexibility for future savings and income needs in retirement. At the same time, investors should be cautious not to lose sight of their long-term financial goals by focusing too much on short-term tax considerations. In the end, it's more about achieving goals than realizing tax savings.

T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i.) avoiding any tax penalties or (ii.) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article.