Like most of the country, you likely were caught up in the riveting political theater earlier this year over healthcare reform. But it probably didn't cross your mind that the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act, both signed into law in March, might affect IRA planning.

Think again. There may not be any healthcare provisions that directly affect IRAs and other retirement plans, but there certainly are some indirect effects. The part of the new law most likely to affect clients is a 3.8% levy on investment income. (It's called an additional Medicare contribution, but it's really a surtax on net investment income.)

Of course, distributions from retirement plans are excluded from the list of investment income items, which includes taxable interest, dividends, capital gains, rents, royalties, passive activity income and taxable payouts from annuities. But distributions from traditional IRAs and Roth IRA conversion income will increase a client's modified adjusted gross income (MAGI) and may increase exposure to the 3.8% surtax.

MORE MAGI

The good news is that this tax won't take effect until 2013, so there is some time for planning. Also, the 3.8% surtax on investment income won't affect all your clients equally. In fact, it's likely that some, if not many, of your clients won't be affected at all-at least not immediately. The new investment surtax will only apply to clients whose MAGI exceeds $200,000, or $250,000 for married couples filing joint returns. For this purpose, MAGI is calculated to be a taxpayer's regular AGI, plus any foreign income excluded from AGI.

As with the thresholds for the alternative minimum tax (AMT), the surtax threshold amounts are not indexed for inflation. If Congress does not pass further legislation to increase these amounts, it's likely that this provision will affect more of your clients as time passes, especially if they have not taken steps to avoid it.

In any event, clients with income below these MAGI levels will not be subject to the surtax. Keep this in mind while planning income for 2013 and future years. To be effective, that planning process should begin now.

This example shows how IRAs will interact with this new surtax: Assume John and Jane Smith, who file a joint return, have $280,000 of gross income in 2013. That income includes $230,000 of earned income plus $50,000 of interest from their bank accounts.

The 3.8% Medicare surtax is imposed either on net investment income or on the amount of MAGI over the threshold amount, whichever is less. For the Smiths, this means the lesser of $50,000 (net investment income) or $30,000 ($280,000 - $250,000 = MAGI over the threshold amount for joint returns). The $30,000 of MAGI over the threshold amount for joint returns is less than their $50,000 of net investment income, so they will owe a 3.8% surtax on $30,000 of their investment income.

To illustrate how an IRA distribution or income from a Roth conversion might affect a client's exposure to the investment income surtax, let's change the example slightly. Now, suppose the Smiths are both 72 years old in 2013, and they each take required minimum distributions (RMDs) from their IRAs, for a total of $35,000 in 2013.

Those RMDs boost the Smiths' MAGI from $280,000 to $315,000. Now they're $65,000 over the $250,000 MAGI threshold in 2013, but still only have $50,000 of investment income. All $50,000 of their investment income would be subject to the 3.8% surtax.

The $35,000 of RMDs results in all of their investment income being taxed at 3.8%. If the Smiths owe 39.6% (the highest tax rate scheduled for 2013) in ordinary income tax on those RMDs, the 3.8% surtax raises their tax rate on a portion of their RMDs to 43.4%.

Here's another example. Suppose Mark and Molly Jackson, also joint filers, have MAGI of $240,000 in 2013: $140,000 from earnings and $100,000 of net investment income. At this income level, the Jacksons would not be subject to the 3.8% surtax, as their MAGI is under the $250,000 threshold.

Let's say the Jacksons decided to convert Mark's $500,000 traditional IRA to a Roth. Now the Jacksons have MAGI of $740,000, which is $490,000 over the threshold. Their entire $100,000 (the lesser of $490,000 or $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 conversion by $3,800.

CONVERT NOW

Perhaps the best IRA-related advice you can give clients is to convert traditional IRAs to Roth IRAs before 2013. Early conversions may reduce the impact of the 3.8% surtax in several ways.

First, converting to a Roth before 2013 avoids the surtax on the conversion. For clients who do 2010 Roth conversions and elect to include all the income in 2010, the income will be taxed no higher than 35%. If future rates remain unchanged, a conversion after 2012 might be taxed as high as 43.4%.