With the enactment of an enhanced federal role in medical care comes the need for revenue enhancement. The age of the Obama tax hikes has officially begun. The big news for high-income folks is a new 3.8% "Medicare" tax on investment income and an additional 0.9% Medicare tax on wages, both of which are to take effect in 2013. But workers at all income levels could be squeezed by new limits on medical flexible spending accounts and medical deductions.

The 3.8% investment tax, combined with the expected (and Obama- favored) Jan. 1, 2011, expiration of the Bush tax cuts for high-

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income taxpayers, would produce a 2013 top federal income tax rate of 23.8% on long-term capital gains from the sale of securities, up from 15% now. The top rate on interest, rents, royalties and certain "passive income" would rise to 43.4% from 35%. (Neither 2013 rate includes the return next year of the phaseout of itemized deductions for the better off, which can add one percentage point to both rates.)

"The high-net-worth, high-income taxpayers - they are in the crosshairs. They have a target on their backs and their fronts,'' says Mitchell A. Drossman, national director of wealth planning strategies for Bank of America's U.S. Trust unit.

Play defense. Consider these strategies now.

FSAs and Medical Expenses
Beginning next year money stashed in pretax FSAs, health savings accounts and health reimbursement accounts may no longer be used for over-the-counter medications other than insulin, unless prescribed by a doctor. (For more on these plans, see Fighting The High Cost Of Healthcare.)

Even more significantly, beginning in 2013, the amount you can shelter pretax in an FSA will be restricted to $2,500 a year, an amount that will then be indexed for inflation. (Currently there's no legal limit, and 78% of large employers set it at $5,000 or higher, according to Hewitt Associates).) That means you should plan to put aside pretax money in 2011 or 2012 for such big-ticket items as orthodontia and Lasik surgery. You must have the procedure done that same year, since any pretax money not used each year is forfeited.

Note that it will also become more difficult as of 2013 to write off out-of-pocket medical costs on your 1040 - taxpayers under 65 will be able to deduct such costs only to the extent they exceed 10% of adjusted gross income, up from 7.5% now. (Older taxpayers can still use the 7.5% threshold through 2016.)

Roller Coaster
The top tax rates on both capital gains and ordinary income are heading back up again.

Additional Medicare Wage Tax
Beginning in 2013 there's an additional 0.9% Medicare tax on gross compensation - meaning before 401(k) or other pre-income-tax deductions - of more than $200,000 for individuals or $250,000 for couples. This tax is paid solely by the employee and is on top of the current 2.9% Medicare payroll tax, split evenly between employer and employee. The new charge, along with the expected 2011 reversion of the 33% marginal income tax rate to its pre-Bush 36% and the 35% top rate to its pre-Bush 39.6%, means high earners should think hard before deferring compensation. Similarly, if you've got nonqualified stock options that you can exercise, consider doing it this year - your gain at exercise is all taxed as compensation, subject to the ordinary income tax plus Medicare taxes, notes Drossman.

If you're well paid, don't marry another high earner. The marriage penalty was already pretty severe for upper-middle-incomers (with typical deductions, two $200,000 earners would see the second income kicked up from 28% and lower brackets to 33%). The penalty will get a lot worse, with a greater gulf between rates in the two highest brackets and rates in the brackets below.

Surtax on Investment Income
There's yet another marriage penalty here, since the new 3.8% investment surtax for 2013 hits singles with more than $200,000 in adjusted gross income and joint filers with more than $250,000. (Unlike the tax brackets, neither threshold is indexed for inflation.) The surtax will apply to interest, capital gains, annuities, rents, royalties, passive activity income and dividends. (It's unclear what the total rate on dividends will be. Obama purports to favor making permanent an expiring provision of the Bush cuts that taxes dividends at the lower long-term capital gains rate. But if Congress doesn't act, the top rate on dividends will zoom from 15% to 43.4%.)

Exempt from the surtax: retirement account distributions, capital gains from selling a principal residence and business income from a venture, such as a partnership or Subchapter S corporation you actively manage. (That means self-employed professionals can still cut their Medicare taxes by incorporating as an S corp. and treating some of their earnings as profits, not wages.)

The new 3.8% surcharge will add yet another way you must figure your tax bill: It applies to the lesser of your net investment income or your adjusted gross income in excess of the threshold amounts. So a couple with $350,000 in salaries and no taxable investment income would pay the 0.9% surtax on $100,000 of salary. A couple with $200,000 of salaries and $150,000 of investment income would pay no 0.9% surtax but would pay the 3.8% surtax on $100,000 of income (the excess of $350,000 over the $250,000 threshold).

The surtax will also apply to trust income in excess of $11,200 that isn't distributed to beneficiaries - bad news for trust fund babies as well as families accumulating money in trusts for kids with special needs.

All these changes make tax-efficient situating of assets more crucial than ever, particularly for higher-income folks. Hold corporate bonds and Treasuries in your tax-deferred accounts and buy tax-exempt municipal bonds for taxable accounts.

Keep individual stocks in taxable accounts so you can harvest losses and benefit from the lower capital gains rate when you sell. If you've still got unrealized losses from the market crash, harvest them and bank them for future use against the higher gains rate. (But when you sell, beware of the wash-sale rule, which says you can't book a tax loss if you buy the same stock or fund in the 30 days before or after selling a loser.) (For more insight, see Tax-Loss Harvesting For An Unsteady Market.)

If you've got big bills coming up in 2011 - say, for college tuition or a home renovation - sell appreciated stock later this year to benefit from the 15% rate, says Timothy Burley, a tax partner with Weiser LLP in Edison, N.J. Drossman adds that if you're taking these gains, you may want to defer realizing losses until next year or beyond, when they can offset gains that are taxed at a higher rate than what you're paying now. Whatever you do, he adds, don't panic and let tax considerations outweigh investment sense, as some folks did in 1986 when the rate was about to go from 20% to 28%. "We're trying to avoid clients making knee-jerk reactions,'' he says.

Roth IRA Conversions
Another issue to consider now: Roth conversions, which were allowed this year, for the first time, for all taxpayers. (Previously, only those with modified AGI of $100,000 or less could do them.) In a conversion you take money out of a traditional pretax individual retirement account, pay ordinary federal and state income tax on it at today's rates and deposit it in a Roth IRA, where all future growth and withdrawals in retirement (or by your heirs) are tax free. (For more insight, see 2010: The Year To Convert Your IRA.)

The looming 3.8% Medicare surcharge makes Roth conversions even more attractive for some upper-income folks, says IRA expert Robert Keebler, a CPA with Baker Tilly in Green Bay, Wis. Why? Even though IRA withdrawals themselves aren't subject to the surcharge, the money you take in retirement from a regular IRA - but not (at least under current law) a Roth - counts in your AGI and can help push you over the $200,000/$250,000 threshold, which makes your other investment income subject to the 3.8% tax. Plus once you hit 701TK2 you're forced to take distributions from a taxable IRA, meaning this isn't income you'll be able to manage or time.

Still, conversions aren't right for every (currently) high-income taxpayer, Keebler cautions. For example, if your combined federal/state marginal income tax rate will be lower in the future, a conversion seldom makes sense. Even assuming Obama's tax hikes remain undisturbed after the next election, your own marginal tax rate could fall if you move into a lower bracket or from a high-tax state, such as New York or California, to one without a state income tax, such as Florida or Nevada.

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