The revenue-raising provision of the new health care law most likely to affect your clients is a 3.8% levy on investment income. The law describes it as an additional Medicare contribution, but it is actually a surtax on net investment income. The good news is that this tax won't take effect until 2013, so there is time to plan.
Clients in the top tax bracket that year (39.6%) will actually pay 43.4%.
The surtax applies to taxpayers with a modified adjusted gross income over $200,000, or over $250,000 for couples filing jointly. For this purpose, MAGI is a taxpayer's regular AGI plus any foreign income excluded from AGI.
Net investment income includes taxable interest, dividends, capital gains, rents, royalties, passive activity income and taxable payouts from annuities — but not distributions from retirement plans, including individual retirement accounts.
At first glance, it might seem that this tax won't apply to IRA planning as distributions from retirement plans are specifically excluded from “net investment income.” But on closer inspection, taxable distributions from IRAs (including Roth conversions) do matter because they increase MAGI, which may increase the amount of investment income that is subject to this surtax.
Suppose Mark and Molly Martin would have MAGI of $240,000 — including $100,000 of net investment income — in 2013. They convert Mark's $500,000 traditional IRA to a Roth IRA.
Now the Martins have MAGI of $740,000, which is $490,000 over the threshold. All $100,000 of net investment income will be subject to the 3.8% surtax.
Here, the 3.8% surtax raises the effective tax on the Roth IRA conversion by $3,800, or 3.8% of $100,000.
If that is how the 3.8% tax will work, how can you help clients plan for it?
Perhaps the best IRA-related advice you can give to clients is to convert traditional IRAs to Roth IRAs before 2013. Such conversions may reduce the impact of the 3.8% surtax in several ways.
First, converting to a Roth IRA before 2013 avoids the surtax issue. Indeed, a 2010 conversion will be taxed no higher than 35%; a conversion after 2012 might be taxed as high as 43.4%.
Also, converting all or part of a traditional IRA to a Roth IRA means reducing or eliminating future required minimum distributions. In turn, not having to take such distributions may help clients reduce MAGI and minimize their exposure to the 3.8% surtax.
For example, Bob will have to take his first required minimum distribution in 2013. His 2012 year-end account balance will be $2,500,000.
Based on his life expectancy, Bob has a required minimum distribution of $91,241 for 2013. That distribution won't be subject to the 3.8% surtax, but the taxable amount of that distribution will be part of Bob's MAGI for 2013.
If it pushes Bob's income over the threshold amount, Bob's net investment income will become subject to the surtax. Bob can avoid this potential problem by converting the IRA to a Roth IRA.
Bob will have no required distributions from a Roth IRA. In addition, if Bob takes distributions from the Roth IRA to supplement his income, he won't run the risk of pushing his MAGI over the threshold for the 3.8% surtax.
The tax on a Roth IRA conversion ideally should be paid by tapping non-IRA assets, thus reducing future net investment income from those assets that might otherwise be subject to the 3.8% tax.
The 3.8% surtax will hit trusts especially hard. It kicks in when trust income reaches the top brackets, which in 2013 will be about $12,000 of income.
If your client has named a trust as the IRA beneficiary, inherited IRA funds held in the trust will likely be subject to a 43.4% tax at low income levels. Directing the client to convert that IRA to a Roth IRA before 2013 will eliminate this trust tax problem because required minimum distributions from inherited Roth IRAs will generally be tax-free.
The bottom line is that income will be more highly taxed in the future. High-income (not necessarily high-net-worth) clients will be the prime targets.
Reducing reported income will be critical. Converting to a Roth IRA now will reduce or eliminate taxable RMDs in the future while providing a source of future tax-free cash flow for clients and their beneficiaries.
Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
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