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
- Annuities
- 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.

In past MFA blogs on the subject of Roth IRA conversions, we’ve discussed how to determine if a Roth conversion makes sense for you; we’ve highlighted the estate planning benefits of a Roth IRA; and we’ve outlined several conversion strategies worthy of consideration (segregation strategy and arbitrage strategy).

By now, countless individuals have decided that a Roth conversion makes sense for them, but many are still perplexed by how to determine the best option for paying the tax on a 2010 conversion. Normally, an individual would be required to report all of the income (as ordinary income) from a Roth conversion on their 2010 tax return. However, for those who convert in 2010, a special provision offers flexibility in deciding when to report the conversion income. This special tax deferral rule, which presently applies to 2010 conversions only, allows an individual the option to report half the income from the conversion on their 2011 tax return and the other half on their 2012 return. Essentially, that means spreading the tax burden over a three-year period.

For example, if an individual holds a traditional IRA worth $500,000 and they convert the entire amount to a Roth IRA in 2010, they can report the entire $500,000 on their 2010 tax return or, alternatively, they can report half of the resulting income ($250,000) on their 2011 federal tax return and the other $250,000 on their 2012 return. The taxes on the 2011 income are due by April 15, 2012 and the taxes on the 2012 income are due on April 15, 2013, although an individual might have to make quarterly estimated tax payments for those years. In some cases, this could allow for a very meaningful deferral of tax payments.

Deferring any conversion tax as long as possible might seem like a no-brainer, but unfortunately, it’s not that simple. Bear in mind that just because the income is evenly split over two years, that does not necessarily mean the tax is evenly split as well. Much depends in part on an individual’s 2010 income, deductions, tax credits, and marginal tax rate, versus what these project to be in 2011 and 2012. For some individuals deferring may make the most sense, yet for others it can bump them into a higher tax bracket and/or render them ineligible for certain deductions or credits in not just one year but two, because of the income phase-out impact.

Adding to the confusion is the looming expiration of the Bush tax cuts. If the cuts are allowed to expire, this may result in higher tax rates for 2011, potentially offsetting or exceeding the tax payment deferral benefits.

Of course, assumptions about future taxes, in and of themselves, do not yield a complete analysis of when to report the conversion income. The potential earning power of the retained tax dollars during the deferral time period, inflationary assumptions, as well as an individual’s particular liquidity situation must all be considered. As each IRA owner’s financial and tax situation is different from the next, so too will be the relative value each places on these various factors, further influencing this decision. The key is for each person to make a tax reporting decision most appropriate for their unique situation.

Clearly, there are many issues to consider throughout the process of deciding how and when to pay taxes on a Roth conversion. Individuals should seek the guidance of a skilled practitioner with extensive tax planning experience to ensure conversion taxes are minimized. We at MFA have developed a proprietary approach to analyzing our clients’ particular Roth conversion tax situation and would be more than happy to discuss our methodology with you.

When tax revenues plummeted during the Great Depression, Congress needed a new source of revenue to avoid huge deficits. Partially because it would give them something new to tax, Prohibition was ended and a new excise tax on alcohol helped shore up the sagging budgets on the state and federal levels.

Today, as we climb out of the “Great Recession,” the government is falling behind again. In April the Treasury Department posted an $83 billion deficit, nearly four times larger than April 2009’s and the largest ever for that month. It was also the 19^th consecutive deficit posted, and Uncle Sam is looking for a way to stop that losing streak.

To address the situation, the Obama administration has proposed several changes to the tax code as part of the 2011 budget. Some of these proposed changes directly impact estate and gift tax planning. If the proposals get the approbation of the Congress, they could affect the estate/gift plans of many. If (or until) these tax law changes are approved, readers still have an opportunity to take advantage of some “once-in-a-generation” chances to save money.

Of the proposed estate and gift tax law changes, there are three categories that could have a profound impact on property transfers. The three categories included in President Obama’s proposal include tax basis consistency, valuation discounts, and grantor retained annuity trusts.

- Grantor retained annuity trusts (GRATs) are annuities that have long been popular as a means to transfer large sums of money to a family member tax free. They will remain an option under the president’s proposal, but the minimum term before the beneficiary can receive the corpus will be extended significantly to 10 years. The longer term may make it less likely that the growth benchmark needed for the GRAT (to be an effective wealth transfer vehicle) will be met. Extending the term also makes it more possible that the person establishing the trust could die before the maturity period of the GRAT has been reached.

- The second proposal targets certain restrictions on family controlled entities which might lower the value of a business. If approved, some restrictions (discounts, i.e. lack of control, lack of marketability) will be disregarded for the purposes of valuation assessment in case an ownership stake is transferred by gift or bequest to a family member. If valuation discounts are restricted, transfers of “ownership interest in business entities” will retain their full fair market value. Obviously, the higher the fair market value, the greater the tax paid upon transfer.

- Tax basis, the purchase price of property plus improvements and less depreciation, is used to determine the amount of gain or loss once the property is sold, gifted, or bequeathed. Obama’s proposal seeks to stifle those who would skirt the estate tax by requiring executors of wills to provide both the recipient and the IRS with information on the tax basis of the property inherited.

It’s important to stress that, for now, these are only proposals. Some of these proposals might be enacted as originally drafted, some might be modified as a result of congressional debate, and some might be completely rejected. Nonetheless, it is wise to be familiar with what is currently on the President’s “wish list.”

However, the uncertainty that surrounds them, combined with the certainty of other changes in tax law – next year’s jump in the capital gains tax, for example – means it is more important than ever to have a solid financial and estate plan in place.