President Obama ushered in a new era for American health care this past March when he signed the Patient Protection and Affordable Care Act. A hefty price tag is inevitably attached to such sweeping changes, and to pay for it, Congress has instituted a number of new taxes, fees, cuts, and cost-saving measures. Some high-income taxpayers can expect to see their taxes go up as a result of the law, but there are ways to offset the burden.
A new 3.8% Medicare tax, for example, is being imposed on the lesser of either (a) net investment income or (b) the excess of Modified Adjusted Gross Income (MAGI) over the threshold amount (for married couples filing jointly -$250,000; for married individuals who file separately - $125,000, and for single taxpayers - $200,000). For purposes of the 3.8% tax, “net investment income” includes:
- Interest, Dividends and Capital gains
- Rents, royalties and passive activity income
Though the new Medicare tax won’t take effect until 2013, the time to begin planning is now. Certain investments such as municipal bonds, tax-deferred non-qualified annuities, and life insurance can be utilized to reduce an individual’s MAGI, and thus their tax liability under the new law. Contributions to retirement plans such as a 401(k), 403(b), or IRAs can also assist with reducing one’s MAGI.
With the Bush-era tax cuts expected to expire (at least for the wealthiest Americans) at the end of 2010, the role Roth IRAs can play in reducing liability with the new tax will be even greater. Minimum Required Distributions (MRD) from traditional IRAs, due to the tax-deferred component of the distribution, will increase MAGI, possibly above the threshold amount. Roth IRA distributions, on the other hand, will not count towards MAGI, making a Roth conversion an attractive option for some.
Unless Congress takes action, those in the 35% tax bracket for 2010 could see their top tax rate rise to 39.6% beginning in 2011. In 2013, the 3.8% surtax will create a bubble in which investment income could be taxed as high as 43.4%. Appropriately planning to mitigate or eliminate this new tax could save individuals as much as 8.3% in additional tax.
For example: “Sally is a single taxpayer with $200,000 in annual investment income. This income alone, being below the threshold, is not subject to the surtax. If in the following year, Sally receives an additional $100,000 distribution from her traditional IRA account, her MAGI would rise above the threshold and that additional income would subject her to an additional $3,800 of tax. However, if that distributions came from a Roth IRA, her MAGI would remain at $200,000 thus negating the potential impact of the additional 3.8% surtax for that year.”
A multi-year projection of expected taxable income can help determine whether or not a conversion in 2010, or even 2011 or 2012, may help. The first step is to determine how much any future projected minimum required distribution would put you above the MAGI threshold. If you expect your traditional IRA distribution to subject your investment income to the 3.8% surtax, you may want to further consider a Roth conversion.
When doing these projections, the guidance of a trusted advisor is invaluable. There are numerous factors and variables to consider when performing income tax projections, especially when the tax projections encompass more than one year. It is a challenging exercise and one that can be best performed by a seasoned tax professional.