This is the fifth in our series on Roth conversions and tax rates. (For earlier ones, click on the “Roth conversion” tag below this entry.) Our focus here is on how the new Medicare tax on investment income may affect planning for a Roth conversion in 2010 — even though the new tax doesn’t take effect until 2013.
We took a first look at the Medicare tax on investment income last week. Briefly, beginning in 2013 taxpayers will pay a 3.8% Medicare tax on their investment income or the amount by which their overall income exceeds $200,000 ($250,000 on a joint return, $125,000 if married filing jointly), whichever is smaller. The tax applies to the typical items we think of as investment income — interest, dividends, capital gains, annuity income and so forth — but income from a qualified retirement plan, including an IRA, is not considered investment income for purposes of this tax.
Although IRA income is exempted from the tax, this income can make a difference in whether investment income rises above the threshold that applies to overall income.
Example: In a year after 2012 when the new tax applies, you’re single and have $150,000 of income from an IRA plus $180,000 of investment income. The tax will apply to $130,000 of the investment income, because that’s the amount by which total income ($330,000) exceeds the $200,000 threshold. If you eliminated the income from the IRA, however, you would eliminate the Medicare tax on your investment income, because the entire amount would fall below the threshold.
If you can anticipate being in this position, you’re an ideal candidate for a Roth conversion even before taking the Medicare tax into account:
- You have money invested in a taxable account that can be used to pay the conversion tax, effectively increasing the amount of money you’re sheltering in a retirement account (see earlier articles in this series for explanation).
- Unless your investment income consists largely of long-term capital gain, you’re likely to be incurring a marginal rate of tax on your IRA income that’s close to, or above, the maximum rate of 35% you would pay on a Roth conversion this year if you elect out of delayed income reporting for the conversion.
Despite these highly favorable conditions, reports indicate that many wealthy taxpayers are reluctant to move forward with a Roth conversion. A combination of factors is likely at play, including a distaste for paying tax earlier than necessary even if it will save more tax down the line, failure to fully understand the benefits of a Roth conversion, and financial planning’s all-time nemesis, inertia.
I suspect that for many of these people, throwing the Medicare tax into the mix could tip the balance. The prospect of eliminating this tax on some or all of one’s investment income in years after 2012 should be highly motivating. What’s more, a financial projection that takes the Medicare tax into account in estimating the amount of wealth that can be preserved into later retirement years or passed on to heirs could produce stunning results in some fact patterns.
The opportunity to reduce or eliminate the Medicare tax on investment income through a Roth conversion will in most cases be significant only to people who would benefit from a conversion strategy even without the tax. For people who fully understand the potential benefits of a Roth conversion it provides icing on an already rich cake. For those who don’t, it may provide motivation to do something that’s already advantageous.
This article has been corrected. The rate of tax for the Medicare tax is 3.8%, not 3.9% as stated in the original article.
Tags: feature, Medicare tax, Roth conversion
Isn’t the Medicare tax equal to 3.8%, not 3.9% as the article indicates? Small correction, if accurate, but just making sure I understand what the right number is.
Thanks for catching our typo. The correct rate of 3.8% appears in our earlier article on this tax. The article has been corrected.