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.
CONVERT BY YEAR-END
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
What if your client has large itemized deductions, so large that they reduce taxable income substantially? Will that reduce his modified adjusted gross income for the 3.8% surtax?
The answer is no. Itemized deductions are known as below the line deductions. They do not reduce adjusted gross income and, in turn, do not reduce modified adjusted gross income. But, investment interest expense would reduce investment income for purposes of the 3.8% surtax, since the surtax is based on net investment income.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of several books on IRAs.