Obamacare Effect on Roth Conversion

[joefotz]

There is a popular Roth conversion proponent out there (not Ed) that said that the new 3.8% Medicare tax on investments that starts in 2013 is another reason to convert earlier rather than later. All of my research on this topic has found that since the converted dollars are not counted as part of the MAGI that this new tax utilizes in its calculation this is not the case, and therefore, this tax does not come into play for Roth conversions. Is he correct?

[alan-oniras]

I have not located anything to suggest that the MAGI used for these purposes is any different than the MAGI on Form 1040. If so, even though the 3.8% Medicare Tax does NOT apply to IRA or QRP distributions, a Roth conversion that contributes to exceeding the MAGI of 200,000/250,000 would trigger the tax on the types of investment income (interest, dividends, cap gains etc) that would not be taxed if MAGI was under the threshold. In that sense, a Roth conversion could trigger the additional tax of 3.8% on some or all of the investment income.

We also know that a Roth conversion done currently can trigger the surcharge for Part B premiums. However, as in the situation above, you also need to consider that triggering these taxes in the conversion year may also result in avoiding those same taxes in future years because your RMDs or other pre tax distributions will have been reduced as a result of the conversion.

[joefotz]

To sumarize, the conversion amount has the possibility of causing investment income to be subject to the 3.8% tax that otherwise would not have been due to the conversion causing a breech of the threshhold? If there were no investment income the converted amount could not cause exposure to the 3.8% tax in any way?
Lastly, I have a related question; it would follow that a qualified withdrawal of contributions from a Roth that had met their 5 year vesting period could neither be subject to the 3.8% tax nor cause investment dollars that would otherwise not be subject to the tax to be hit with the tax?

[alan-oniras]

Correct. If these is no investment income, the converted amount could not result in exposure to the 3.8% tax.

Also correct on the effects of a qualified Roth IRA distribution. There would be no taxable income reported on line 15b of Form 1040 and therefore there would not be any taxable implications of that distribution, direct or indirect.

[joefotz]

At the risk of beating a dead horse, since the 3.8% tax is technically on the lessor of (i) annual net investment income or (ii) the excess MAGI above the threshhold......could you also confirm whether or not converted amounts can add to MAGI such that they become subject to the tax?
For example; for a couple married filing jointly with $200,000 of earned income that also converts $100,000 to Roth, the excess $50,000 over the $250,000 threshhold is or is not subject to the 3.8% tax?

ps. Alan, your answers are terrific! They are direct and conclusive. Thanks.

[bsteiner]

The 3.8% Medicare tax affects the decision as to the Roth conversion in a couple of ways.

First, even though IRA distributions are not directly subject to the Medicare tax, they increase the modified adjusted gross income, which may push more of the investment income above the $250,000 (joint) threshold. For example, suppose a couple's only income is $300,000 of investment income. They'll pay the Medicare tax on $50,000. If they also had $100,000 of required distributions from an IRA, their total income would be $400,000, and they would pay Medicare tax on $150,000 of their investment income. They can avoid this by converting before 2013.

Second, by using their nonretirement assets to pay the tax on the conversion, they'll have less investment income, which may reduce their Medicare tax.

In addition to the Medicare tax, the 2001 and 2003 income tax rate reductions are scheduled to expire at the end of this year. The President has proposed allowing the top two brackets to revert to their pre-2001 levels (in other words, the 33% bracket would revert to 36% and the 35% bracket would revert to 39.6%), except that taxpayers with income under $200,000 (single) or $250,000 (joint) would not pay more tax than they do now. Of course, there is no way to be sure what future tax rates will be. But if future tax rates increase, that favors the Roth conversion.

Someone with income over $250,000 may want to discuss this with his/her own attorney or other advisors.

[joefotz]

How the conversion dollars can cause investment income to become subject to the 3.8% tax is understood, both in the original response from Alan and in the latest response. What remains unclear is whether in the absense of investment income whether or not a conversion can cause earned income that without the conversion would not be subject to the tax to become subject to it. Again, the cause for the inquiry is because the tax is on the lessor of investment income (in this example none) or excess MAGI above the threshhold (in the example the income only rose above the threshhold if conversion dollars are included). All would be clarified by knowing if the $50,000 in the example in the previous post would be subject to the 3.8%.

[alan-oniras]

>>>>>>For example; for a couple married filing jointly with $200,000 of earned income that also converts $100,000 to Roth, the excess $50,000 over the $250,000 threshhold is or is not subject to the 3.8% tax? >>>>>>>>>>

Joe, I think the your questioned copied above is the one you want clarified. In this case, the 3.8% tax would NOT apply as there is no investment income to tax. Of course, when you do a 2010 Roth conversion and defer the income, you become exposed to other possible tax consequences for 2011 and 2012 since tax legislation in the nature of Bruce's prior post has not yet been debated. But if there is some draconian tax passed effective after this year, you could still either recharacterize your 2010 conversion or opt out of the two year deferral. The deadline is 10/17/2011 for those determinations.

[joefotz]

Yes that is the scenario in question and I am only inquiring about this particular new on the books tax. I do understand what you are saying the lack of investment income negating the first of the two figures subject to the tax but I am still not sure you are also taking into consideration the fact that the 3.8% tax is on the lesser of TWO figures, the second of which is the amount of MAGI in excess of the $250,000 threshold (for married filing jointly) even if there is no investment income. If this could trigger the tax then the Roth conversion proponent I mentioned in the first entry would be correct, and if not, only correct to the extent that there was investment income per your first response.

[alan-oniras]

The tax applies to the lesser of:
1) The amount of investment income or
2) The amount the MAGI exceeds 200/250

Example 1: Inv Income 40k, MAGI 265k (married)
3.8% tax applies to 15k of Inv income because 15 is less than 40

Example 2: Inv Income 40k, MAGI 350k
Tax applies on 40k of Inv Income because 40 is less than 100

But if there is 0 Inv Income there is no tax since 0 would always be the lesser (or same).

[2beachcombers]

I am in the unfortunate position that my planned Roth conversion in 2010 coincides with the 2 prior yr MAGI for Medicare Part B. My prime objective is to grow Roths tax free; reduce future MRD and provide spouse with only Roths and SS after me. Her tax benefits are significant.

I have converted my IRA to 4 roths with different allocations for cherry picking.

Should I ignore this one year impact of increased part B premium as it appears to be a small one time impact wrt the benefits of future reduced MRD income?(total MAGI can be controlled below 320K$ with various roth conversion options.)
I can also stay below the Obama health care 2013 taxes.

I have considered the 2010 option to split the conversion income but that would just make the one yr problem a two year problem. I have also looked at maintaining each year conversion to manage the Part B premium limits.

Any thoughts; referenced reading or web calculators appreciated

jerry

[alan-oniras]

Jerry,

Have not seen a web calculator that incorporated this added premium, but it is easy enough to assess the additional Part B Premium as an additional marginal income tax rate and therefore a cost of the conversion. In many cases the added premium would be recovered later on when higher RMDs would be avoided by the conversion. Obviously, this is interdependent on other variables as well such as future tax changes, which Part B surcharge tier is triggered, and future unknown investment results in your TIRA had you not converted that would increase those RMDs. In most cases, it is probably not a decision changer. The affect is also reduced with very large conversions since the Part B surcharge is a flat dollar amount and represents a smaller tax rate increase on larger conversions.

Since you may be recharacterizing some of these conversions anyway with the cherry picking strategy, you will know the cost of the conversion including the surcharge prior to the 10/17/2011 recharacterization deadline. That is also the deadline for opting out of the two year deferral and reporting the conversion fully in 2010. As you indicated, you might look at the surcharge tier with the conversion income split over 2 years vrs only one surcharge but maybe a larger one if reported in 2010. But I think this issue will be much smaller than the actual marginal tax rates that surface in 2011 and 2012. Finally, if a VAT tax gains support, it would replace even higher income tax rates in the end, but would reduce the value of your Roth vrs your TIRA.

With all these variables to juggle, the bottom line might be to diversify tax wise with conversions, but not to overdo them and also not to simply retain the TIRA while converting nothing.

[2beachcombers]

Crystal clear. Thanks for confirming my understanding of the complex stuff. Good luck to those who do not use this website.

My plan is convert 50% of My IRA over the next few years and a potential to futher convert in future low income years.
I plan on giving my wife an option to not inherit my remaining IRA and go to the kids. This will reduce her SS taxable amount significantly. Am I correct that a IRA can also be used for Nursing home care w/o being taxed?

jerry

[alan-oniras]

Of course, if your wife inherits your ROTH, those distributions will not affect SS taxation. Distributions from the TIRA will have to be included in AGI, other than those attributed to non deductible contributions. Nursing home expenses or other high medical costs come in as itemized deductions subject to 7.5% of AGI and these deductions can offset a large part of the TIRA distribution income. What this means is that someone without long term care should not convert their entire IRA since the taxes for these distributions are mostly covered by the itemized deduction.

[2beachcombers]

Alan, again thanks, now I finally see a good reason to hang on to some of my IRA

Another question-- what are you refering to in your previous post(your quote below) about a conversion surcharge/[i]

Is this the Medicare Part B premium?

"Since you may be recharacterizing some of these conversions anyway with the cherry picking strategy, you will know the cost of the conversion including the surcharge prior to the 10/17/2011 recharacterization deadline"[/color][/color]

jerry