9 Ways to Beat the Medicare Surtax – Part 3

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9 Ways to Beat the Medicare Surtax - Part 3

This week we conclude our series on minimizing the new 2013 taxes on upper income taxpayers (see Part 1 and Part 2). Not only did the new year bring new taxes but a higher level of complexity as well. The new term “net investment income (NII)” is added to the tax code due to the Medicare surtax created in the 2010 healthcare reform act. NII has yet to be fully defined by the IRS which makes tax planning even more challenging. The IRS issued proposed regulations recently on what they will consider NII. They expect to announce final regulations later this year.

Adding to tax planning complexity the stealth increases created by restoring the phase-out of itemized deductions known as Pease Limitations and personal exemptions (PEP) can add another 2-6% to the top rate. Tax strategies which were successful in the past may be thwarted by triggering these phase-outs.

Minimizing the impact of these tax increases requires a plan and strategy for implementation. This week we will finish up this series with the last 3 strategies.

9 Ways to Beat the Medicare Surtax – Part 3

7.) Roth ContributionsUpper income taxpayers may not be able to make a direct Roth contribution. There are income limits phasing out a taxpayer’s ability to contribute. In 2013, single taxpayers and heads of household who are covered by a retirement plan at work begin to phase out contributions when Modified Adjusted Gross Income (MAGI) is between $59,000 and $69,000. Joint filers in which an IRA contributor not covered by a retirement plan and is married to someone who is covered phase out when MAGI is between $178,000 and $188,000.

Even if your income is above the threshold you can still get money into a Roth IRA in a round-about way. There are no income limits for making a non-deductible IRA contribution. The new limit on annual contributions rose to $5,500 in 2013. The catch-up provision for anyone age 50 or older increases the maximum to $6,500. Since 2010, there are no income limits for converting a traditional IRA to a Roth IRA. A high income taxpayer simply makes a non-deductible contribution to an IRA and then converts it to a Roth IRA. This strategy of indirectly contributing funds into a Roth IRA may not be effective for taxpayers who already have substantial amounts invested in a traditional IRA because of the “pro rata rule (PDF).” This rule requires a taxpayer to include all IRA assets when determining the taxes due on a Roth conversion. While investing indirectly in a Roth IRA isn’t appropriate for everyone, it can provide a viable option to those with higher incomes who are otherwise unable to contribute to a Roth.

Roth Conversions – The taxable distribution created by converting a traditional IRA to a Roth isn’t considered NII but it still increases MAGI which could subject other income into NII. However, Roth conversions shouldn’t be ruled out. Long term tax planning should take into consideration the benefits of Roth conversions today to lessen Required Minimum Distributions in the future.

8.) In general, a conversion may be a good idea if:

  • You don’t plan to touch the money in the Roth for at least the next five years.
  • You can pay the income taxes due on the conversion without using funds from the traditional IRA when you convert.
  • You don’t expect to need income from the Roth IRA and want to build an estate for your heirs. In this case, the Roth IRA can minimize the overall income tax burden to the family; heirs get the proceeds free of income taxes, and in the interim, the proceeds can continue growing free of taxes.
  • You don’t expect to need income from your IRA, and you wish to avoid the annual mandatory distributions required from a traditional IRA when you reach age 70½.
  • You believe current income tax rates are at the lowest level we’ll ever see and Congress will most likely increase tax rates even more in the years to come.

9.) Hire a Financial Adviser – Advisory fees have always been a deductible expense for taxpayers who itemize. The IRS allows a tax deduction for certain investment-related expenses reported on Schedule A under miscellaneous itemized deductions subject to the 2%-of-AGI floor, and an AMT adjustment. The IRS has also determined the calculation to determine NII includes deductions properly allocable to earning gross investment income. Section 212 of the Internal Revenue Code details the deductibility of expenses associated with an individual’s financial issues. There are three categories of deductible costs:

  • for the production or collection of income;
  • for the management, conservation, or maintenance of property held for the production of income; or
  • in connection with the determination, collection, or refund of any tax.

Advisory fees can be used to reduce NII subject to the surtax and then deducted on Schedule A to reduce overall income taxes. Most importantly, a competent financial adviser will help you develop a strategy to minimize your total tax bill while helping you achieve your financial goals.

Don’t put off 2013 tax planning until the end of the year. Look for ways to plan income and change investment strategy throughout the year to avoid a year end scramble. Roth conversions, 401(k) elections, and harvesting capital losses should all be planned now to minimize your total tax bill.

Part 1 | Part 2

Rick’s Insights

  • Be sure you understand the pro-rata rule before you fund non-deductible IRAs you intend to convert to a Roth.
  • Roth conversions increase MAGI but they can still be an important part of a long-term tax strategy.
  • A good financial adviser can help you develop a strategy to lower you tax bill and the advisory fee is a deductible expense.

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