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Tax Planning for Affordable Care Act Subsidies

The Affordable Care Act creates a new tax credit for certain taxpayers purchasing health insurance via one of the new insurance exchanges. The idea of the credit is to subsidize the cost of health insurance for those who might not otherwise be able to afford it.

To be eligible for the credit, your “household income” must be between 100% and 400% of the federal poverty level. For example, in 2013, 400% of the federal poverty level would be $45,960 for a family of one, or $62,040 for a family of two.

For these purposes, “household income” means the adjusted gross income (plus any foreign earned income, tax-exempt interest income, and tax-exempt Social Security benefits) of everybody who is being counted in the household for the purposes of this credit (i.e., the taxpayer, his/her spouse, and dependents). Note that adjusted gross income (AGI) is not the same as “taxable income.” AGI is the bottom line on the first page of your Form 1040. That is, it’s the figure before backing out the standard deduction (or itemized deductions) and personal exemptions.

For somebody who has qualifying coverage for the entire year, the credit is calculated as:

  • The annual premium for the second lowest cost “silver” plan available in the exchange, minus
  • A specified percentage of the taxpayer’s household income (ranging from 2% for taxpayers with household income close to 100% of the federal poverty level, to 9.5% for taxpayers with household income closer to 400% of the federal poverty level).

The credit is, however, limited to the total amount spent on premiums for qualifying health plans — which could be relevant if you decide to purchase a plan that’s less expensive than the second lowest cost “silver” plan.

In other words, the effect of the credit is that qualifying taxpayers will not have to spend more than the applicable percentage of their income (2% to 9.5%, depending on income level) on health insurance premiums — unless they purchase coverage that’s more expensive than the “silver” plan used in the calculation of the credit.

Tax Planning Ramifications

If you buy insurance via one of the new exchanges and you have the ability to keep your household income below 400% of the federal poverty level, the new tax credit effectively results in you having a higher marginal tax rate than your ordinary income tax bracket — because additional income will not only cause additional income tax according to your tax bracket, it can also cause the amount of your Affordable Care Act subsidy/tax credit to go down.

As you might imagine, a change in your marginal tax rate has numerous tax planning ramifications. With regard to portfolio management, the two biggest categories of changes that come to mind are:

  1. Retirement account-related decisions, and
  2. Capital gain/loss management.

With regard to retirement account-related decisions (for people who qualify or almost qualify for the credit):

  • People who are still working will find tax-deferred contributions (as opposed to Roth contributions) more advantageous than they would otherwise be, because they could increase the amount of the credit.
  • People in retirement (specifically, early retirement, because this credit is only relevant before Medicare kicks in) will find that financing spending via distributions from tax-deferred accounts will be less advantageous than it would otherwise be, because such distributions could reduce the amount of the credit or make them ineligible for the credit.
  • And people (regardless of whether they’re retired or still working) will find Roth conversions to be less advantageous than they would otherwise be, because the conversion could reduce the amount of the credit or make them ineligible for the credit.

As far as capital gain/loss decisions go, I think the biggest impact will be that taxpayers who might otherwise benefit from tax-gain harvesting (to take advantage of the fact that long-term capital gains in the 10% and 15% tax brackets are not taxed at all) may want to avoid (or postpone) harvesting their gains, because the increase in household income could make them ineligible for the credit.

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