Whether they are still working or have already retired, clients with high incomes who execute Roth IRA conversions or take required minimum distributions from traditional IRAs starting this year might owe the 3.8% surtax as well as ordinary income tax.
Given that the top federal income tax rate was expected to rise this month to 39.6%, from 35%, the total tax on a future Roth IRA conversion or traditional IRA distribution could be as high as 43.4% (39.6% 3.8%).
Roth IRA owners never have to take required minimum distributions. Therefore, converting a traditional IRA to a Roth IRA can reduce a client's future modified adjusted gross income and reduce exposure to both higher ordinary tax rates and the 3.8% surtax.
Furthermore, since qualified Roth IRA distributions are tax-free, qualified Roth IRA distributions that are taken voluntarily in the future won't increase a client's modified adjusted gross income and cause other investment income to become subject to the surtax.
Of course, clients may be reluctant to pay tax sooner than they must. Converting, say, a $400,000 traditional IRA to a Roth IRA could produce a $140,000 tax obligation at a 35% rate or more.
Ideally, the tax on a Roth IRA conversion will be paid from non-IRA funds, leaving more to compound, potentially tax-free, inside the Roth account. If a client draws down his taxable portfolio to pay this tax, that will leave fewer taxable investment assets and perhaps less investment income in the future; this will also reduce exposure to this surtax.
In essence, a Roth IRA conversion last year would have moved a client's investment assets from highly taxed to potentially untaxed territory (all withdrawals are tax-free after the owner has had the Roth IRA for more than five years and is at least age 59 1/2).
Of course, a full or partial Roth IRA conversion may not be suitable for every client. But it is a conversation worth having with high-income clients, even if rates have just gone up, so clients are aware of their options and the tax consequences.
ESTATES AND TRUSTS
The 3.8% surtax affects trusts and estates as well as individual taxpayers. The calculation is a bit different, though. For estates and trusts, the 3.8% surtax applies to the lesser of (1) any undistributed net investment income or (2) the amount of modified adjusted gross income subject to the top tax rate for estates and trusts.
Trust income in excess of about $12,000 will be taxed at the highest ordinary rate, which was scheduled to be 39.6% for this year. Undistributed net investment income is net investment income (interest and dividends) that is earned by the trust in a given year and not passed out to trust beneficiaries within the same accounting period.
Some clients want to leave IRAs to a trust, perhaps to prevent the beneficiaries from squandering or mishandling this inheritance. Therefore, the 3.8% surtax could affect some clients with modified adjusted gross income far below $250,000 or even $200,000.
EXAMPLE: TRUST INCOME
A woman died last year and left her $1 million IRA to a trust. Her daughter is the trust beneficiary. Assume the trust qualifies as a see-through trust and that required minimum distributions are to be taken by the trust over the daughter's life expectancy. If the daughter is 57 in 2013, her life expectancy is 27.9 years. Therefore, the trustee must withdraw at least 1/27.9 of the $1 million inherited IRA balance in 2013, or $35,842.
Now imagine that the trustee has the discretion to retain any or all of the inherited IRA distribution in the trust and dole out funds to the daughter as needed. In this scenario, since the required minimum distribution alone, if undistributed, would push the trust income over the trust modified adjusted gross income threshold, all of the trust's net investment income will be subject to the 3.8% surtax.
As time goes by and money in the trust accumulates, more investment income is likely to be generated, and such income may be taxed at extremely high rates.
Clients often have strong reasons for leaving their IRA to a trust, though, and the 3.8% surtax, along with high trust tax rates, may not be enough to change their minds.
For such clients, a lifetime conversion to a Roth IRA can have post-death benefits. Roth IRA distributions won't raise a trust's modified adjusted gross income and may help to rein in the taxes that will be owed. In addition, the client still retains the post-death control desired.
EXAMPLE: BIG DEDUCTIONS