Thinking of a Roth Conversion? See How a New Surtax May Affect You

Income taxOne of the provisions of the Healthcare bill that was signed into law in March, 2010 is a brand spanking new tax – a surtax on investment income over certain amounts.  This surtax will come into play beginning in 2013.  The amounts are, admittedly, rather high, but nonetheless will impact a lot of folks.  What you may not realize is that, due to the application of this surtax, it could be more beneficial to do a Roth IRA conversion now, at the “old” tax rates, or even spread the tax over the next two years (as is allowed for conversions completed in 2010 only).  By doing so, you could avoid getting hit with the new surtax, and likely reduce the bracket that you have to pay from for all income.

The New 3.8% Surtax

Here’s how the new 3.8% surtax is applied:  beginning in 2013, a tax will be imposed for each taxable year, equal to 3.8% of the lesser of 1) net investment income; or 2) the excess of Modified Adjusted Gross Income over the threshold amount. So, in order to understand what this means, we need to define a few things. Net Investment Income – this is the total of all interest, dividends, annuities, rents, royalties, income from passive activities, and net capital gains from disposition of capital property not held in an active trade or business.  The IRS has specifically excluded the following from Net Investment Income:
  • Income (including self-employment income)
  • Distributions from IRAs or other qualified plans
  • Gain on the sale of an active interest in an S Corporation or partnership
  • Items that are otherwise excluded from income, such as interest from tax-exempt bonds
Modified Adjusted Gross Income – for the purpose of the surtax, this is simply your Adjusted Gross Income (Form 1040 line 37) plus the net amount related to the foreign earned income exclusion. NOTE:  THIS IS NOT THE SAME AS THE MAGI THAT YOU USE TO DETERMINE YOUR ELIGIBILITY FOR VARIOUS IRA DEDUCTIONS OR CONTRIBUTIONS.  You can find that calculation by reading “Determining Your MAGI”.  Don’t confuse the two, as they are completely different calculations – thanks, IRS!  To keep the confusion at a minimum, I will explicitly refer to this Modified Adjusted Gross Income as Modified AGI within this surtax context. Thresholds – the thresholds for applying the surtax are as follows:
  • $250,000 for filing status of Married Filing Jointly
  • $125,000 for filing status of Married Filing Separately
  • $200,000 for filing status of Single or Head of Household (yes, Virginia, it is more tax efficient to be single)

Initial Examples

Now that we know the definitions, let’s look at a couple of examples to see how the surtax would be applied: Example 1. Joe and Mary, a married couple filing jointly, have net investment income of $100,000 and pension income of $125,000.  They are also taking distributions from their IRA in the amount of $50,000, which brings their Modified AGI to $275,000.  So in 2013 Joe and Mary will be subject to the surtax on the lesser of their net investment income ($100,000) or the amount of their Modified AGI over the threshold ($275,000 minus $250,000 equals $25,000). In this case, the amount of the Modified AGI over the threshold is the lesser amount, and so Joe and Mary will have to pay the surtax on $25,000, or $950 in surtax. Example 2. Les, a single taxpayer, has net investment income of $75,000, and pension and other income of $130,000.  Les also takes a distribution each year from his IRA, in the amount of $25,000.  Les’s Modified AGI, combining of all of this income, is $230,000, which is over the threshold.  Applying the calculation, Les will owe the surtax on $30,000 – which is the lesser of his two amounts (Modified AGI of $230,000 minus $200,000 threshold equals $30,000, which is less than his net investment income of $75,000).  The surtax will be $1,140.

How a Roth IRA Conversion Could Help

You’ve undoubtedly heard and read a lot about the 2010 Roth IRA conversion privilege – where there’s no income limit on doing the conversion, and you can elect to spread the tax over the following two years if you like.  This overall concept should be considered by all folks who have IRAs, especially folks with higher incomes.  This is especially true if future (taxable) distributions from traditional IRAs will have an impact on your tax bracket – and potentially cause the surtax to be applied. In Example 1 above, the only reason the surtax was applied at all was because of the IRA distribution.  If Joe and Mary had converted the $500,000 in IRAs to Roth IRAs in 2010, they likely would have paid tax of approximately $170,000 on the conversion amount if they paid it all in 2010.  Spreading the tax over 2011 and 2012 would result in a slightly higher amount of overall tax paid (this is an educated guess), but it could be paid with future income, so this option should be examined. The real benefit is that now, with all of their IRA money in the Roth account, they can take the same net yearly distributions without being subject to the surtax in 2013 and thereafter, since the Roth distributions are not included as part of the Modified AGI.  When the tax on distributions from the traditional IRA is taken into account (at the new, improved rates including the surtax), the breakeven point for the Roth conversion tax occurs within six years. After that point, under present tax law, the amounts withdrawn from the Roth IRA could be considered completely beyond the affect of tax. In Example 2, Les was already going to be subject to the surtax even without the IRA distribution.  If we assume that Les also had $500,000 in his IRA account, converting that amount to a Roth IRA would result in tax in 2010 again of approximately $170,000 attributed to the conversion.  As in the Joe and Mary example, spreading the tax over 2011 and 2012 would also result in a slightly higher overall tax paid. Applying the same breakeven analysis to Les’s situation, assuming he continues to take distributions from his Roth IRA in the same amounts (which are now tax free and not subject to the surtax), the breakeven point for Les will take considerably longer, something like 17 years.  This is because the amount of his distributions was considerably less than Joe and Mary’s, and therefore less future tax is saved each year.  Of course, in both cases, as the tax rates increase from future tax law changes, the breakeven point would reduce.


While the surtax on its own should not be a reason to enact a Roth IRA conversion, one of the tenets that we’ve talked about in the past that can cause the conversion to work in your favor is a future increase in tax rates.  Since we know that tax rates are going to increase in 2011 (see “Income Tax Rate Changes After 2010” for details), adding this surtax in 2013 increases the potential tax even more, for some folks.  With these two known increases in tax rates, if you’re in a position to be impacted by the surtax, you should review the impacts of a Roth IRA conversion, definitely before the rates rise in 2011.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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