Taxes on investment income next year are just one part of the Patient Protection and Affordable Care Act of 2010 that was upheld by the Supreme Court.
For certain clients, the crucial change will be the 3.8% surtax on investment income (interest, dividends, capital gains, etc.). Roth IRA conversions and traditional individual retirement account distributions aren't considered investment income, yet they can trigger the surtax.
Raising modified adjusted gross income via IRA distributions and Roth conversions can push a client above the applicable threshold amount, causing them to be subject to the 3.8% surtax. Similarly, a higher MAGI also may increase the amount of investment income that is subject to this surtax.
The first point to keep in mind is that this surtax affects only “high-income” clients. For the purpose of this surtax, that is anyone with MAGI of more than $200,000 or married couples with MAGI of more than $250,000 on a joint return.
Keeping those MAGI numbers in mind, the 3.8% surtax will be assessed on an amount over those thresholds. The tax will be imposed on the lesser of net investment income or the amount of MAGI over the applicable threshold.
Clients with income below these MAGI levels won't be subject to the surtax. This is a key item to keep in mind while planning income for 2013 and future years.
TAKE A BITE OUT OF THE BITE
How can you help clients minimize the surtax bite?
In the retirement-planning area, persuade working clients to maximize deductible contributions to 401(k)s, simplified employee pension plans, profit-sharing plans and so on.
Business owners and professionals might want to consider defined-benefit plans, which may allow extremely large deductible contributions. The more deductible contributions that clients make, the lower their reported AGI, which may help to trim their exposure to the 3.8% surtax.
Given that the top income tax rate is scheduled to rise to 39.6%, from 35%, next year, the total tax on a future Roth IRA conversion or traditional IRA distribution could be as high as 43.4%. Therefore, you might suggest that high-income clients convert their traditional IRAs to Roth IRAs before Dec. 31.
Their tax rate will be no higher than 35%, which could turn out to be much less than they will owe in the future. This year also might be a good time to take long-term capital gains, while the top rate still is 15%.
While a full or partial Roth IRA conversion is not suitable for every client, Roth owners never have to take distributions. Therefore, converting a traditional IRA to a Roth IRA this year can reduce a client's future MAGI and reduce exposure to both higher ordinary tax rates and the 3.8% surtax.
Ideally, the tax on a Roth IRA conversion will be paid from non-IRA funds, leaving more to compound, potentially tax-free, inside a Roth IRA. If a client uses funds from his or her taxable portfolio to pay this tax, that will leave fewer taxable investment assets and perhaps less investment income in the future, reducing wealthier clients' exposure to the surtax.
For a variety of control and creditor protection reasons, some clients will name a trust as their IRA beneficiary. Those clients need to be aware that the 3.8% surtax will hit some trusts hard beginning next year, since the tax kicks in at much lower income levels than for an individual.
A Roth conversion can help avoid this harsh trust tax situation, since post-death required minimum distributions from the inherited Roth IRA retained in the trust will be free of income tax and not subject to the higher trust taxes.
Although the 3.8% surtax may be the most publicized tax change in the new legislation, there is also a 0.9% tax on earned income in excess of $200,000 for individuals and $250,000 for joint filers. This tax, intended to shore up Medicare, also takes effect next year and will be a payroll and self-employment tax.
Contributions to employer plans won't reduce a client's income to escape this tax.
Like the 3.8% surtax on investment income, the earned-income thresholds aren't indexed for inflation. Beginning next year, clients with high investment income and high earned income can get hit both with the 3.8% investment income surtax and the 0.9% additional Medicare tax.
Right now is an excellent time to get in touch with clients who will face the greatest impact from this Supreme Court decision. They are likely to be eager to meet with you to discuss future plans.
Ed Slott, at irahelp.com, is a certified public accountant and IRA distribution expert.
