If you’re on the fence about converting pre-tax assets sitting in your traditional (a.k.a. “regular”) IRA to a Roth IRA, the healthcare act just signed into law just created a big incentive for some folks to take the plunge.

Here’s why: in order to pay for expanded health benefits, the “Health Care and Education Affordability Reconciliation Act of 2010” imposes a surtax- an additional tax- of 3.8% on income from investments. This kicks in once your total income- from all sources- exceeds a certain amount.
According to the Act, this occurs when you:

File Taxes as:

And Your Modified Adjusted Gross Income(1) is more than: 

Married, filing joint

$250,000

Married, filing separately

$125,000

Everyone else

$200,000

 

The first thing you’ll notice in the above chart is that Congress has introduced yet another “marriage penalty.” Regardless how you file your taxes, if you legally tie-the-knot with another individual your “modified adjusted gross income” (MAGI) threshold is a lot lower. Two individuals who simply live together could each earn up to $200,000- for a combined household income of $400,000- and still not be subject to this surtax.

The impact of the surtax- which takes effect in 2013- will be especially significant on those in the top income tax brackets. Starting next year, dividends from stocks will again be taxed at the same rate as “ordinary income” and the highest rate reverts to 39.6%. Adding another 3.8% to that means your investment income could be subject to a tax rate of 43.4%!

CPA Bob Keebler, of the firm Baker Tilly Virchow Krause, points out that while withdrawals from a traditional IRA are not themselves subject to the surtax, they do add to your overall taxable income. As a result, they could increase your MAGI beyond the threshold and make your investment income subject to the surtax.

Although most folks who are still working tend to leave the money in their IRAs unless they absolutely need it, withdrawals become mandatory once you reach age 70½- but only from “traditional” IRAs.

You never have to take a withdrawal from a Roth IRA, which means your investments can continue to grow on a tax-sheltered basis. And, should you need to access the money in your Roth, it comes out tax-free, provided you meet certain requirements (such as being at least 59½). The key is that tax-free Roth withdrawals have no impact on your MAGI. Taking money out of your Roth IRA has no impact on whether investment income will be subject to the surtax.

Let’s take a simplistic example: Suppose you are married, retired, and over age 59½. You have a traditional IRA and your spouse has a Roth IRA. Each one holds $200,000 in assets.

Your joint income consists of $70,000 in Social Security, $40,000 from a pension, and $60,000/year in taxable interest and dividends- a total of $170,000. Under the Healthcare Act, you’d still owe income tax on your $50,000 in investment income, but it would not be subject to the new 3.8% surtax because your total income (MAGI) is less than $250,000.

Now, let’s assume that in 2014 you need $125,000 (to cover repairs to your home, buy a second home or mid-life crisis toy, for medical bills, etc.). If you withdraw this from your traditional IRA, this amount is taxable. It increases your MAGI to $295,000- $45,000 over the threshold for a married taxpayer filing a joint return. Under the new law, this excess amount is assumed to come from your taxable investment income. As a result, you get wacked with an additional $1,710 in tax.

On the other hand, if you take the $125,000 out of your spouse’s Roth IRA, the entire amount is tax-free. It has zero impact on your MAGI, which remains at $170,000. Your $75,000 in investment income is not subject to the 3.8% surtax.

Keebler, who holds a Master of Science degree in taxation, estimates that “85% of Americans” will not be affected by the surtax. About 5%- those whose salary and investment income exceed the threshold- will get hit with it. But his real concern are “normal, retired professionals- doctors, attorneys, architects- who are going to have to work very hard to keep their income below” the threshold amount- especially once they reach the age where mandatory withdrawals from traditional IRAs kick in.

Because of the new Medicare surtax, it’s going to be more important than ever for taxpayers in higher brackets to generate a significant portion of their income via tax-free interest on municipal bonds or tax-free Roth IRA withdrawals. “There’s no doubt that it makes sense to convert to a Roth today,” says Keebler. “Or, at least, figure out how much [of your traditional IRA] you have to convert to stay below the threshold.”

1. Modified adjusted gross income” consists of your “adjusted gross income” (found on Line 37 of IRS Income Tax Form 1040) plus any wages that were subtracted because you earned them outside the U.S. and any income that was excluded because it was earned on foreign investments.

 

Ms. Buckner is a Retirement and Financial Planning Specialist at Franklin Templeton Investments. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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