The combination of the new 3.8 percent Medicare tax and the increased capital gain tax could hit some taxpayers living in retirement hard.
In a note to its retirement planning customers, Fidelity Investments explains that the amount owed is based on the lesser of your total net investment income or the amount of your modified adjusted gross income, or MAGI, that exceeds $200,000 for individuals, $250,000 for couples filing jointly, or $125,000 for spouses filing separately.
Because MAGI includes wages, capital gains and qualified distributions from a retirement plan such as a traditional IRA, 401(k) or 403(b), someone with fairly ordinary income can be subject to big taxes.
People who sell homes in expensive communities are especially vulnerable, says Mark Pruner of Prudential Connecticut Realty in Greenwich, Conn. While couples get a $500,000 tax exclusion on their residence, almost anyone who bought a three-bedroom, two-bath house before 1982 in a city like Greenwich has more than $500,000 in gain, Pruner says.
He points to a sale he closed this week on a three-bedroom, two-bath home in need of a new kitchen and other cosmetic work that sold for $925,000. The seller, who paid a very typical $100,000 for that house in 1982, will owe capital gains taxes on $325,000 at a 15 percent rate, plus the new 3.8 percent Medicare tax for a total of 18.8 percent. If his gain had been more than $450,000, his tax rate would be 23.8 percent.
If this person had taken out a big mortgage in order to send kids to college or buy a second home, he may not make enough from the sale of the house to pay the taxes, Pruner says. "People in these circumstances are going to have to stay there until they die and their heirs get a step-up in value," bringing the worth of the property to current market value so that a sale generally doesn't create much gain.
Pruner thinks it wasn't the intent of Congress to punish people who live in communities such as Greenwich, San Francisco, New York City and other places where the housing is pricey. "People who are going too be hit by this are the heart of America. They bought their homes and lived in them a long time," he says. "Now they are caught in an equity capital gains trap."