The crucial change will be a 3.8% surtax on investment income. For most clients, investment income consists primarily of interest, dividends, capital gains, non-qualified annuity distributions, and rental and royalty income. Traditional IRA distributions, as well as Roth conversions and distributions from company plans, are not considered investment income - and yet these distributions can trigger the 3.8% surtax.
The first point to keep in mind is that this surtax affects only high-income clients; let's regard that as an individual with modified adjusted gross income of more than $200,000, or a married couple with modified adjusted gross income of more than $250,000 on a joint return.
Typically, this amount will be the same as a taxpayer's regular adjusted gross income. Any clients who exclude foreign income from this figure, however, will have to include that amount in their modified adjusted gross income.
The 3.8% surtax will be assessed on the amount exceeding the modified adjusted gross income thresholds. The tax will be imposed on the lesser of net investment income or the amount of modified adjusted gross income exceeding the applicable threshold. Clients with income below these levels will not be subject to the surtax.
IRA and other retirement account distributions are not considered investment income for purposes of the 3.8% surtax.
So where, then, do IRAs come into this calculation? Simply put, IRA distributions can cause other net investment income to be hit with the surtax when that income otherwise would have avoided it.
Here are a couple of examples to review:
EXAMPLE: ROTH CONVERSION
A couple file a joint return and have 2013 modified adjusted gross income of $240,000. They have $60,000 of net investment income, but since they are $10,000 below the joint filer threshold of $250,000, they aren't concerned about the 3.8% surtax. It does not apply to them.
But suppose the couple convert a $100,000 traditional IRA to a Roth IRA this year. Even though their net investment income is unchanged, they now have $340,000 in modified adjusted gross income, so they exceed the joint threshold by $90,000. Now the pair will be required to pay the surtax on their $60,000 of investment income for 2013, since the $60,000 of investment income is less than $90,000, the amount more than the threshold. This creates an additional tax liability of $2,280.
In their case, converting a traditional IRA to a Roth IRA this year triggered a surtax of thousands of dollars where the surtax otherwise would have been avoided completely. Remember, the 3.8% is in addition to the regular income tax the conversion normally generates.
EXAMPLE: IRA WITHDRAWALS
A single filer had $1 million in a traditional IRA at the end of last year. Jane will be 75 this year, so according to the IRS Uniform Lifetime Table, she has a life expectancy of 22.9 years. Besides the required minimum distribution from the woman's IRA, she has $180,000 of other income, $80,000 of which is net investment income.
She would be required to take at least $43,668 from her IRA this year ($1 million divided by 22.9 years). Such a withdrawal would increase her 2013 modified adjusted gross income from $180,000 ($20,000 less than the single-filer threshold) to $223,668.
That puts her past the threshold for single filers; $23,668 (her net investment income exceeding $200,000) will be subject to the 3.8% surtax. Like all clients with sizable required minimum distributions, she could run into this problem year after year, since she is forced to withdraw ever greater percentages of her IRA account as a required minimum distribution.
How can you help clients minimize the surtax bite? One way would be to suggest that clients maximize, or at least increase, deductible contributions or salary deferrals to 401(k)s, SEPs, IRAs and other retirement accounts. Salary deferrals to 401(k)s and similar plans are excluded from gross income, and contributions to retirement accounts are above-the-line deductions, which reduce adjusted gross income (and therefore modified adjusted gross income, as well).
Business owners and very high-income professionals may want to consider defined-benefit plans that, in some cases, allow extremely large deductible contributions.
The higher the deductible contributions that clients make to lower their reported adjusted gross income, the less exposure they will have to the 3.8% surtax. Of course, building up retirement funds at an accelerated rate isn't a bad benefit on its own.
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