How IRA Distributions Impact the 3.8% Healthcare Surtax

How can you and your financial advisor work together to lower your tax liability? One of the questions we often ask financial professionals is, "what have you done to lower your clients' exposure to the new 3.8% healthcare surtax on net investment income?"

If you take an IRA distribution, the 3.8% surtax is NOT assessed on that distribution. Also, the surtax can only affect single filers above $200,000 MAGI (modified adjusted gross income) and married joint filers above $250,000 - but even then, it is only assessed on net investment income.

However, an IRA distribution can push tax filers ABOVE the MAGI thresholds, and in certain cases, trigger the surtax. How? View our IRAtv video below or click here to view the video.

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Slott Report Mailbag: Can IRA Distributions Make Me Susceptible to 3.8% Healthcare Surtax?

This week's Slott Report Mailbag looks into two tricky areas of IRA planning. The first is how IRA distributions affect an individual's income, and in turn, their susceptibility to the 3.8% health care surtax. We then answered a question about the equally problematic Roth IRA 5-year rules. We receive many questions on a process wrought with possible mistakes and penalties - so much so that we created an entire Roth IRA 5-Year Rules pamphlet! Do you know who knows all about the 5-year rules? An Ed Slott-trained advisor in your area.

On to the mailbag...

1. You recently said that a 401(k) distribution would add to your MAGI (modified adjusted gross income) for the purpose of determining if you are subject to the 3.8% healthcare surtax. What about Roth IRA distributions? Would they also count towards your total MAGI income for surtax purposes?

Send your questions to [email protected]

Thanks

Answer:
IRA distributions are exempt from the 3.8% surtax, but taxable distributions from IRAs can push income over the threshold amount, causing other investment income to be subject to the surtax. Because Roth IRA distributions are generally tax-free, they don’t count towards your total MAGI.

2. I have a Roth IRA that is over 5 years old, and last December I converted my Traditional IRA into a Roth IRA (paying the income tax on the non-basis amount on my 2012 tax return), then combined it with my existing Roth IRA. First, was it okay to combine them, and secondly do I have to wait for 5 years until I can withdraw the amount I had converted?

Answer:
It was okay to combine them. There are ordering rules for Roth distributions and all your Roth IRAs are considered one Roth IRA. Your contributed funds will be deemed to be the first amounts distributed. Then your conversion funds, first in, first out. If you are younger than age 59 ½ when you withdraw conversion funds within five years of the date of conversion, you’ll be assessed the 10% early distribution penalty on the amount that was taxable when you converted. The last funds out are earnings. To have a tax and penalty free distribution of earnings, the distribution must occur at least five years after the date you established your first Roth IRA and after you are age 59 ½ or dead, disabled, or for a first time home purchase.

3. We are looking to convert an IRA to a Roth IRA. We took a loss on a variable life policy that was converted to an annuity. Can we use that loss to offset the tax due on a Roth conversion?

Answer:
The conversion of the IRA to a Roth IRA is treated as ordinary income on the tax return. You can only offset that income with deductions that will offset ordinary income. You should consult with your tax preparer to see if this particular loss qualifies to offset his ordinary income.

-By Joe Cicchinelli and Jared Trexler

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The 3.8% Health Care Surtax: Your Questions, Our Answers

So far this year, we've received a lot of questions on the new 3.8% health care surtax, so we decided to take a few of the most frequently asked questions and answer them here, so that everyone can benefit from them.

In general, what is the 3.8% health care surtax? We have been writing about it (for our loyal readers) as far back as 2010. Here are links to a few other articles to well verse you on the topic before reading the questions and answers below.

3.8% Surtax: What You Need to Know
What the Supreme Court Ruling on Health Care Law Means For Your Taxes
10 Ways You Might Pay More Tax in 2013
An Open Letter of Retirement Planning Advice to President Obama

Question: Are my Social Security benefits subject to the 3.8% surtax?

Answer: No, although your Social Security benefits generally increase your MAGI (modified adjusted gross income), causing some or more of your other net investment income to become subject to the 3.8% surtax.

Question: I have net investment income from things like interest, dividends and capital gains. Do I automatically have to pay an additional 3.8% surtax on income from these sources?

Answer: No, not automatically, but you may have to. If you’re single and have MAGI over $200,000 or are married and file jointly with more than $250,000 of MAGI, then at least some of your net investment income will be subject to the surtax. However, if your MAGI is below these thresholds, then you will not owe any 3.8% surtax at all.

Question: Since the 3.8% surtax wasn’t effective until January 1, 2013, I don’t have to worry about it until I file my 2013 taxes next year, right?

Answer: Not necessarily, especially not if you are one of the millions of taxpayers that pay their tax liability through estimated payments throughout the year. The 3.8% surtax (as well as the new 0.9% Medicare surtax and the new top long-term capital gains and ordinary income tax rates) must be factored into your estimated tax payments. There are multiple ways you can set up estimated tax payments in order to avoid penalties, so it’s probably best to speak to your tax advisor to find out what’s best for you.

Question: Will any distributions from my IRA be subject to the 3.8% surtax?

Answer: No, but just like Social Security benefits, your traditional IRA distributions generally increase your MAGI, causing more of your net investment income that was previously not subject to the 3.8% surtax to become subject to the 3.8% surtax.

For example, suppose you are married and file a joint return and, in 2012, you had $230,000 of income, all from interest, dividends and capital gains. If your income is exactly the same this year, you won’t owe any 3.8% surtax because you would be below the $250,000 MAGI threshold.

However, let’s imagine things stay the same next year except for the fact that you turn age 70 ½ and take your first RMD (required minimum distribution) of $70,000. Now you are $50,000 over the threshold and even though you have no more investment income than you had this year, $50,000 of it will be subject to the 3.8% surtax, putting an extra $1,900 of your money into Uncle Sam’s pockets. Roth IRA distributions generally will not affect your MAGI.

Question: If I don’t owe any 3.8% surtax this year, is it safe to assume that I’ll probably avoid it in future years as well?

Answer: Nothing is safe to assume when it comes to taxes. You know the old saying, when you assume…Well it definitely applies here. Your income might change significantly from one year to the next, but even if it doesn’t, chances are as time passes more and more people will become subject to the 3.8% surtax. Why? Because the thresholds (other than for trusts and estates) are not adjusted for inflation each year, so as inflation takes effect and incomes increase, more and more people will be ensnared by the 3.8% surtax.

- By Jeffrey Levine and Jared Trexler

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The Roth Conversion Decision Just Got Tougher

As much as we like Roth conversions and encourage individuals to convert, we do realize that Roth conversions aren't for everyone. There have always been many factors to consider before doing a conversion. With the passage of the 2012 tax act on January 2, 2013 and with the healthcare surtaxes taking effect in 2013, there are now more factors to consider.

One of the things clients worry about when doing a conversion is the effect on their income taxes. In 2013, we now have an additional tax bracket, 39.6%; we have the phase-outs of itemized deductions and personal exemptions; and we have the addition of the surtax on net investment income, 3.8%. Not only do we have these new tax considerations, but they all become effective at different levels of income and on different types of income.

We generally advise that the income tax due on the converted amounts should be paid with outside assets and not be taken from the retirement account. Many times that involves the sale of investment assets with the accompanying capital gain taxes. There is now an additional capital gain rate of 20%. The sale of investment assets could also put the client at risk of becoming subject to the 3.8% net investment income surtax. Those are just two more things to consider when contemplating the value of a Roth conversion.

The new law also changed the rules for doing an in-plan Roth rollover (IPRR). The IPRR is an optional feature for employer plans, it is not mandatory. Under the new rules, if an employer plan has a Roth feature, and if the employer plan allows for IPRRs, any employee can do the IPRR. Under the old rules you had to be eligible to take a distribution from the plan in order to do the IPRR. This puts the IPRR in the reach of any employee. The biggest drawback to the IPRR is that there is no recharacterization allowed. Once you do the rollover to the Roth, you are stuck. There is no undo allowed, you will have to pay the tax owed on the conversion.

This is just one more thing to consider when determining whether or not to do a Roth conversion. Should you convert your IRA funds or should you convert your plan funds?

To sum it all up, there are now more items that the conversion could affect on your tax return; you need to be more thoughtful about where your income comes from to mitigate the impact of the investment surtax; you have to decide whether to do the conversion in an employer plan or outside of a plan and you still have to consider factors that have not changed under the 2012 tax law such as the effect of the conversion income on your tax bracket; if you are older - the effect of the conversion income on Medicare Part B premiums; if you are younger -the effect of the conversion income on financial aid you or a family member is receiving; will your taxes be higher when you retire; what will be your sources of income when you retire; what will be the source of the funds to pay the tax on the conversion.

There is a lot to think about, which is why we suggest having a Roth conversion conversation before deciding to go through with the conversion itself.

The best piece of advice we can give you is that you should work with a financial professional when you are considering doing a Roth conversion. You can find a listing of Ed Slott trained advisors on our web site, www.irahelp.com.

Article Highlights:

• The Roth conversion decision just got tougher with a new income tax bracket and new 2013 healthcare taxes on net investment income
• Other points to consider: will the conversion be in an employer plan or outside the plan; what effect will the conversion have on Medicare Part B premiums or financial aid for you or a family member; what will be your tax rate when you retire; what will be your sources of income when you retire and more.

-By Beverly DeVeny and Jared Trexler

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Accelerating the Sale of Appreciated Capital Gain Property: A Strategy Worth Considering

As you are now no doubt aware, there are any number of ways which you might pay more in taxes for 2013 than you will this year (in case you missed it, click here to read my article on 10 of those ways). One of those many ways is when you sell long-term capital gain property. Common types of capital gain property are stocks, bonds, mutual funds and real estate. To be considered “long-term,” you must have held the investment for more than one year.

Currently, the maximum rate you will pay on the sale of most long-term capital gain property is 15% of the gain. Next year, that’s scheduled to jump to 20% (a 33% hike), and if your unfortunate enough to get hit with the new 3.8% health care surtax as well, you could pay up to 23.8%, which is almost 60% more in tax than you would ever have to pay this year!

One of the nice things about investing though is that you can, in some ways, control your tax liability. For instance, suppose you purchased $10,000 of XYZ Corp. in your regular brokerage account several years ago. Now that stock has appreciated in value and is worth $20,000. How much tax do you owe? You might be tempted to say $1,500 (15% times your $10,000 total gain), but that wouldn’t necessarily be the case. In fact, it would only be the case if you chose to sell your investment. That’s because during the time you own a capital investment, such as a stock, bond, real estate, etc., gains and losses are generally deferred.

Most people - including most CPAs - try to put off paying taxes for as long as possible, and usually that’s a good thing. After all, isn’t that the reason so many of us contribute to a traditional IRA, 401(k) or similar type of tax-deferred account? As a result, people often hold onto investments for long periods of time. In fact, sometimes people are so averse to paying tax that they hold onto an investment long after they should, perhaps incurring investment losses that far exceed any tax they would have paid.

If, however, there was ever a time to sell appreciated property before you otherwise intended to, it could very well be now. Why not sell your long-held investment now and lock in the low 15% rate still in effect through the end of this year? Sure, you will be paying taxes before you have to, but you could be paying them at a significantly lower rate than you would in the future. In some sense, it’s
very similar to a Roth IRA conversion, where you pay taxes on your retirement account sooner than you would otherwise have to, but with the idea of locking in today’s “low” tax rates in the process.

What if you really like a stock and don’t want to be without it? No problem. You could sell your XYZ stock at 10:00 AM tomorrow to lock in the current 15% long-term capital gains rate and buy it back one minute later at 10:01 AM. You might be thinking to yourself right now, “Isn’t there some sort of rule stopping me from doing that? Don’t I have to wait more than 30 days or something like that?” If this thought is running through your mind, you’re probably thinking about the “wash sale” rule.

Fortunately, in our example, the wash sale rule doesn’t apply. The wash sale rule deals with losses, but here, we’re talking about selling investments with a gain. When/if you repurchase the same investment, your new cost basis will be the amount you paid when you repurchased it. Any future gain could still be taxed with the 20% rate - 23.8% with the surtax - but the tax would only apply to the gain above your new, higher basis.

Should you choose to take advantage of this strategy, I have one additional suggestion. Consider using non-investment money, such as money in a savings or money market account, to pay the tax. You’re probably not making much in the way of interest on those funds these days and this way, if you decide to reinvest your funds, you’re not reducing the amount to be invested by the tax you voluntarily chose to accelerate paying. You should not, however, leave yourself without enough money to meet your ongoing expenses and cover yourself in the event of an emergency.

Of course, like most planning strategies, this idea is not for everyone. Here are four groups of people who should probably not “sell early” to lock in today’s cheaper tax rates.

#1 - You expect to be in the lowest brackets in the future
If you expect your income to decrease substantially in the future, you may not want to sell your long-term capital gain property now. Although the maximum rate you could pay on the gain is 20%, plus an additional 3.8% for the health care surtax, if your income is fairly modest, you might owe as little as 10%.

#2 -You’re terminally ill
It’s hard to write about stuff like this, but it’s also an important consideration. If you are very ill and probably won’t sell your investment before you pass, you’re probably better off holding onto it. Capital assets receive what’s known as a “step-up in basis” after death. This means that whatever the value is on your date of death, that’s your heir’s new basis. So let’s assume you bought a building in 1950 for $50,000 and now it’s worth $2,000,000. If you sell the property before year-end you’re looking at close to a $300,000 tax bill. That’s better than it would be next year, but, on the other hand, assuming it’s still worth the same $2,000,000 at the time of your death, your heir could sell it for that price and pay no income tax whatsoever.

#3 - You’re never going to sell
This is really kind of an extension of #2. If you plan to hold your investment forever, there’s no point in selling now. Remember, if you never sell a capital investment, you’ll never trigger the capital gains tax, no matter how much gain you have. Plus, as noted above, when you ultimately pass those assets to your heirs, they will get a step-up in basis and may be able to sell the property on their own with little or no tax consequence.

#4 - You’re going to give it away to charity
When most people think about making charitable contributions, they usually think about donating cash or putting it on their credit card. You can, however, donate capital assets, such as stock, which in some cases may be a better move. When you donate capital assets to a charity, you don’t have to pay tax on any of the gain, plus, you get to take a charitable deduction for the full value of your investment (subject to the overall charitable contribution limits). For example, let’s say you bought ABC stock for $10,000 in 1990 and now it’s worth $110,000. If you donate that stock to charity, you’ll avoid the $15,000 ($100,000 gain x 15%) capital gains tax you would have owed had you sold the stock, plus you’ll get a $110,000 charitable contribution deduction (subject to the overall limits). The cherry on top is that for the charity, the $110,000 in stock is an equivalent donation to $110,000 since qualified charities don’t pay any income tax, including the capital gains tax on appreciated investments.

A Final Word
If you’re not one of these people, you should probably check with your tax or financial professional to see if there are other factors that may make this strategy favorable or not. Remember though, in order to lock in today’s low rates, you’ve got to sell by December 31st, so don’t wait too long, or this opportunity might pass you by.

Article Highlights:

• Currently, the maximum rate you will pay on the sale of most long-term capital gain property is 15% of the gain. Next year, that’s scheduled to jump to 20% (a 33% hike)
• Use non-investment money, such as money in a savings or money market account, to pay the tax
• Selling capital gain property is not for everyone, like if you are expecting to be in a lower tax bracket in the future, if you are terminally ill, if you are never going to sell or if you are going to give it to charity

-By Jeff Levine and Jared Trexler

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Planning NOW: 3 Questions to Ask Before the End of the Year

Thanksgiving is here - and the end of 2012 (believe it or not) is right around the corner. That means "year-end planning" time, and below we offer 3 questions you should ask (and find answers to) before year-end.

1) Should I convert all or a portion of my IRA to Roth IRA in 2012?

Right now, in 2012, the highest federal income tax rate is just 35%. In 2013, the highest rate is scheduled to be 39.6%, or roughly 5% higher. Of course, the highest rates are just for those lucky enough to enjoy incomes substantial enough to get to that point. In 2012, that meant close to $400,000 of taxable income, which is your income after all of your deductions and exemptions have been factored in.

So what if you’re in a lower bracket? No big deal right? Not so fast. Although President Obama campaigned on a platform that called for the Bush-era tax cuts to remain in effect for married couples with incomes less than $250,000 and single filers with incomes less than $200,000, those extensions still require Congressional approval. While both parties agree that they would like to see these cuts extended, they disagree about other aspects of the Tax Code, and thus, a deal on those cuts is far from guaranteed.

If Congress does not extend the Bush tax-cuts for those with incomes below the aforementioned limits, pretty much everyone will be impacted. Even those with the lowest levels of taxable income would see their tax bill rise, as the lowest bracket that currently exists, 10%, is set to be eliminated altogether and replaced with a 15% rate. Meanwhile, the 25% tax rate that many middle income Americans enjoy would be replaced with a 28% rate. Those who are currently in the 28% and 33% marginal brackets would see those rates increase to 31% and 36% respectively. Bottom line… If nothing changes, no one is safe from higher taxes. So regardless of whether your income is high, moderate or low, now is a good time to consider a Roth conversion, locking in today’s “low” tax rates for your hard-earned retirement funds.

What happens if you convert now and Congress acts late this year - or even early next year - to extend your current tax rates? That’s a good, no wait - great - problem! Maybe the conversion is still right for you, but if not, don’t forget the Roth recharacterization. Remember, as long as you file your return or your extension on time, you can recharacterize, or undo, your 2012 Roth conversion until October 15, 2013 and get all the tax you paid on the conversion back.

2) What can I do to minimize my exposure to the 3.8% health care surtax?

Beginning in 2013, a new 3.8% surtax on net investment income is set to kick in for certain taxpayers. If you are a single filer and have income of more than $200,000 or are married and have income of more than $250,000, you could be hit with the surtax. The tax is only going to be assessed on the income above your applicable threshold that’s attributable to net investment income. That means there are two ways you reduce your exposure to the surtax if you are likely to be impacted.

Strategy #1 - Reduce your overall income so that your total income drops below your applicable threshold

Strategy #2 - Reduce your net investment income

Approaches to these strategies include transitioning taxable bonds to tax-free municipal bonds, increasing the use of life insurance, using non-qualified annuities to help “shield” capital gains, dividends and interest from being taxable and, of course, Roth conversions.

#3 - Should I sell any of my taxable investments before the end of the year?

Right now, in 2012, the maximum tax rate you can pay on most long-term capital gain investments is 15%. Next year, the maximum rate on the same investments is scheduled to be as high as 23.8% when you factor in both the scheduled increase in long-term capital gains rates and the health care surtax (see question #2). That means that you could pay nearly 60% more in taxes if you sell appreciated long-term gain property next year, or after, instead of 2012.

Normally, when you sell investments at a gain, it’s also a good idea to see if you can sell some investments at a loss to offset those gains, resulting in a lower, possibility $0 tax bill on your sales.

This is commonly known as tax-loss harvesting, a strategy frequently employed by many tax professionals and portfolio managers. While tax-loss harvesting is still worth considering before the end of the year, it may also pay to “keep losers in the till” until next year, when they will be “worth” more since they could cancel out gains that would be taxed as high as 23.8%, as opposed to canceling out gains taxed at a maximum of 15% this year. Long-term and short-term capital gains and losses are first netted separately, and then against each other.

Article Highlights

• Have the Roth conversion conversation because taxes are on the rise in 2013
• Plan to combat the 3.8% surtax on net investment income due from the implementation of Obamacare
• Think about whether you should sell any of your taxable investments before the end of the year

- By Jeffrey Levine and Jared Trexler

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10 Ways You Might Pay More Tax in 2013

The debates are over and we are now less than two weeks from the election! There's a lot riding on this election for both nominees and both parties, but more importantly, for the American public as a whole. While there are numerous issues that will no doubt require the next President's attention, along with that of our lawmakers, few issues are likely to generate more interest from the American people than the subject of taxes.

For some time now, we've had it pretty good, at least from a tax perspective. That's all about to change though. There are an abundance of changes to the tax law scheduled to take effect in 2013 and they are almost universally going to take a bigger chunk of your money and hand it over to Uncle Sam. Old or young, rich or poor, it really won't matter. If nothing changes between now and the end of the year, you're likely to pay more in taxes next year than you are this year. While ordinary income tax rates get much of the press, there are a lot more ways your tax bill might rise. With that in mind, let's take a look at 10 ways you could very well pay more tax in 2013 than you will in 2012.

Ordinary Income Tax Rates
The Bush era tax cuts that were extended in 2010 are set to expire at the end of this year. If that happens and Congress takes no action, rates for most taxpayers, on both ends of the income spectrum, would increase. For instance, right now those who pay tax at the lowest rate pay just 10% in federal income tax. That number would jump to 15% next year. Similarly, the very highest income tax rate one can pay in 2012 is 35%. The highest rate in 2013, if nothing changes, will be 39.6%.

Sources of income that are subject to ordinary income tax rates include your salary, self-employment income, alimony, interest, short-term capital gains and the portion of your Social Security included in gross income.

Capital Gains
If you hold a capital asset for longer than one year, you get a special tax break on any profit when you sell it. Instead of having the profits subject to ordinary income tax rates, you get to pay tax at long-term capital gains rates, which are more favorable. Like the ordinary rate increases we’re set to see in 2013, the changes in the long-term capital gains rates will impact you, no matter what end of the income spectrum you happen to be on. Currently, if your marginal ordinary rate (the highest ordinary income tax rate you pay tax at) is 10% or 15%, you don’t pay any tax on long-term capital gains. If nothing changes, that nice 0% rate (sure can’t beat that) will become up to 10% next year. At the other end of the spectrum, the maximum long-term capital gains rate is 15% (a savings of almost 60% when compared to the top ordinary rate of 35%). Barring Congressional action between now and next year, the top long-term capital gains rate will be 20%.

Long-term capital gains rates apply to the profits on capital assets held longer than one year. Capital assets include stocks, bonds and real estate, including any portion of your primary residence that is not excluded from income.

Qualified Dividends
The economy generally runs better when people are investing their money in businesses and not just leaving it in the bank. In an effort to encourage more people to invest in businesses, Congress created a special tax break for “qualified dividends,” which are simply dividends that have met certain criteria outlined in the Tax Code. Once again, if nothing changes, taxpayers of all income levels will be hit harder in 2013. The current tax rates for qualified dividends are the same as long-term capital gains rates. If you are in the 10% or 15% marginal ordinary income tax bracket you pay a 0% tax rate on qualified dividends. If you are in one of the higher brackets, you pay a 15% rate.

The rate on qualified dividends isn’t simply scheduled to increase next year. Oh no… it’s much worse. Qualified dividends, as things stand now, won’t even exist next year. Instead of getting a tax break, dividends will be taxed at ordinary income tax rates at whatever marginal bracket you happen to be in, just like your interest is now.

FICA
In 2011 Congress passed what was widely referred to as the “payroll tax holiday.” In essence, it was a one year reduction, from 6.2% to 4.2%, in the amount of FICA (Social Security) taxes taken out of a worker’s paycheck. Self-employed persons received a similar break. The tax break was popular enough that is was later extended through the end of 2012. To this point, Congress has taken no action to further extend this deadline, so workers can expect to see more money taken out of their checks for FICA beginning January 1st.

Once again, taxpayers at all ends of the spectrum will feel the pinch. The 6.2% FICA rate scheduled to be in effect for 2013 is a flat rate, meaning those who earn $10,000 salaries will pay the same 6.2% rate that those making $100,000 will. Those with substantial earned income will not only see their FICA tax rate increase, but more of their income will be subject to the tax. In 2012, only the first $110,100 of earned income was subject to the tax. In 2013, up to $113,700 of earned income will be subject to the tax. As a result, those with high income could pay nearly $2,500 more in FICA tax next year.

The FICA tax is assessed on earned income, both from wages and self-employment. You cannot reduce your FICA tax with deductions on your return.

3.8% Health care Surtax
As if it’s not bad enough that nearly all the rates on various types of personal income are set to increase next year, we’re going to add a brand new tax to the mix as well. If you are a high-income taxpayer, beginning in 2013, you may be hit with an additional 3.8% surtax on all or a portion of your “net investment income.” This 3.8% surtax only applies if your net investment income is above your applicable threshold. If you are married and file a joint return, the threshold is $250,000. If you are single, the threshold is $200,000.

The 3.8% surtax will be assessed on the lesser of the amount of income you are over your applicable threshold or your total sum of investment income. Investment income includes capital gains, interest, dividends, taxable distributions from non-qualified (not retirement account) annuities and rental income (unless that is your business). Earned income, as well as IRA and other retirement account distributions, are not net investment income, but could increase your total income, causing other net investment income to become subject to the surtax.

0.9% Medicare Surtax
Is all your income earned income? If so, you don’t have to worry about the 3.8% surtax on net investment income, but that doesn’t mean you’re out of the woods either. Beginning in 2013 certain higher earners will be hit with an additional 0.9% Medicare Tax (we wrote a Tuesday article about this tax). The thresholds for the new Medicare surtax are the same as the thresholds for the 3.8% healthcare surtax, except here, the only income considered is earned income. Married couples who file a joint return and have combined earned income above $250,000 will be hit with the 0.9% surtax on any excess above that amount. If you are a single filer, you’ll be affected in a similar manner, but on earned income exceeding $200,000.

Earned income includes both wages (salary from an employer) and self-employment income.

Return of Exemption Phase-outs
The loss of personal exemptions is yet another way your tax bill might be a higher in 2013. Under the current law, there is no limit to the amount of income you can have in order to claim personal exemptions. To put it another way, in 2012, even Bill Gates and Warren Buffet can claim personal exemptions. Unless Congress takes action to extend this benefit, the same will not be true next year. Married couples filing a joint return will begin to see their personal exemptions phased out at around $260,000. Single filers will start to see their exemptions phased out at about $175,000 of income (although the President’s budget calls for that number to be closer to $210,000).

In general, you are allowed a personal exemption for yourself and, if you are married and file a joint return, one for your spouse as well. If you claim any dependents, such as a children, you can generally claim an exemption for them as well. An exemption for the same person cannot be claimed on multiple tax returns.

Estate Tax
I hope you’re sitting down for this one. If nothing changes between now and next year things in the estate tax area are about to get bad… real, real bad. Beginning in 2013, there will be three major changes to the estate tax law, and all of them could cause you to pay more taxes. A lot more. The first major change to the estate tax is that the exemption amount is scheduled to drop from the current $5,120,000 all the way back down to $1,000,000. In other words, right now, as long as the total value of your taxable estate is less than $5,120,000 you will owe no federal estate tax, but next year, if your taxable estate value exceeds just $1,000,000 your estate will be subject to federal estate tax.

The second big change to the estate tax law beginning in 2013 is that the rate, itself, is scheduled to increase. As noted above, right now the first $5.12 million you leave to someone other than your spouse can generally pass completely estate tax free. However, if you happen to have an estate with a total value in excess of that amount and you pass away in 2012, any excess would only be hit with a maximum estate tax rate of 35%. In contrast, for deaths occurring on or after January 1, 2013, the maximum estate tax rate is set to increase to 55%! Yep, that’s right. A whole lot more of your estate could be hit with a tax that’s a whole lot higher.

The final big change to the estate tax law that’s scheduled to take place in 2013 and could cause you to pay a lot more in tax is the loss of “portability.” In essence, portability is simply a way to transfer any exemption you have remaining after your death to a surviving spouse without the need for any sophisticated estate planning. If you are married, this can effectively double the amount of assets you can pass estate tax free to children, grandchildren, etc. to $10.24 million. At that number, very few estates should be hit with estate tax. In the past, preserving one’s exemption for a surviving spouse was impossible and the only way to make use of the exemption at the time of the first spouse’s death was to give assets immediately to someone other than the surviving spouse or to use of a special type of trust, known as a credit shelter, or A-B trust. For those passing away in 2013 or later with estates in excess of $1 million, credit shelter trusts may once again become a critical planning vehicle.

The only good news in this area is that it seems like both Republicans and Democrats agree that the estate tax laws for 2013, as scheduled now, seem a little harsh. Though they disagree on the extent of the relief they want, the fact that there is common ground might be cause for optimism that at least some facet of the estate tax law (e.g. the rate or exemption) will be made more palatable.

Gift Tax
The current lifetime gift tax exemption is $5.12, just like the estate tax exemption. The two exemptions are actually unified, meaning that any amount you give away during life that eats into your lifetime gift tax exemption will reduce the amount you can transfer after death estate tax free. For instance, if you gifted $2 million to a child last year and pass away before the end of this year, you can still pass $3.12 million ($5.12 current exemption - $2 million gifted in life). Like the estate tax exemption, the gift tax exemption is scheduled to drop to $1 million. Therefore, if you have a large estate, making a large gift before the end of 2012 should be a topic of conversation between you and your tax and/or financial advisor.

Note: In 2012 you can gift $13,000 per person before using any of your lifetime exemption. In 2014 that amount is increasing to $14,000.

The gift tax issues for 2013 also mirror the estate tax issues in other ways. For instance, like the estate tax, the gift tax rate is scheduled to increase from the current maximum of 35% to 55%. The gift tax exemption is also portable in 2012, a feature that is set to be eliminated beginning in 2013.

GST Tax
The Generation Skipping Transfer, or GST, tax is one of the taxes you pretty much want to do anything possible to avoid (I said avoid, not evade! I know this seems bleak, but don’t go getting any funny ideas on me now.) The GST tax is an additional tax on top of either estate or gift tax, when you transfer property down more than one generation. Most commonly, this comes into play when you are gifting (during life) or bequeathing (after death) your assets to a grandchild or great grandchild, although gifts to non-relatives 37 ½ years or more younger than you would also be hit with the tax.

Under the current law, the GST exemption is $5.12 million. Sound familiar? That means you can give/leave up to $5.12 million to a grandchild completely transfer (gift/estate and GST) tax free. That opens the door for some serious legacy and multi-generation planning opportunities. Those opportunities are not going to stick around forever though. As it stands now, the GST exemption is scheduled to go back down to $1 million in 2013.

Note: Unlike the estate and gift tax exemptions, the GST tax exemption is not portable.
The current GST tax rate is also a “favorable” 35%. Beginning in 2013, that rate, like the estate and gift tax rates, is scheduled to go back up to 55%. That 55%, if nothing changes, could be imposed along with a 55% estate or gift tax. It’s also worth remembering that transfer (estate, gift and GST) taxes are imposed not on the recipient(s) of the assets, but rather, on the donor.

- By Jeff Levine and Jared Trexler

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Instant IRA Success Roundtable: October and Year-End Deadlines, Health Care Tax Issues

We just returned from Instant IRA Success, which took place this past weekend (September 29-30) at The Cosmopolitan in Las Vegas. The entire Slott Report staff got together to discuss important October and year-end deadlines and the tax issues involved with the Affordable Care Act.  You can view our Instant IRA Success roundtable below, and view any of our other IRA, retirement and tax planning videos are our YouTube page, IRAtv.



-Compiled by Slott Report staff

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Health Care Taxes, NUA, Inherited IRAs and RMDs Highlight Mailbag

The Slott Report Mailbag was full of questions that will keep us busy through the summer!  This week we answered a pressing question on taxes relating to President Obama's Health Care Law, Net Unrealized Appreciation (NUA) strategies, inherited IRAs and required minimum distributions. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Send questions to [email protected]

I recently attended a seminar where Mr. Slott was a keynote speaker and thoroughly enjoyed his presentation.

I understood him to say that income in the future, as a result of the forthcoming "Fiscal Cliff," with no further legislation, would be taxed at higher than current rates and subject to a 3.8% tax (on investment income) to finance the Health Care Reform. Since he also spent a good amount of time discussing Traditional IRA to Roth IRA conversions, I thought that the Traditional IRA distributions would also be taxed the additional 3.8%. However, in a recent article by Eaton Vance, I noticed that the Health Care Reform tax would not apply to amounts withdrawn from qualified retirement plans and IRA’s.

Can you tell me if your interpretation of the 3.8% Health Care Reform tax exempts amounts withdrawn from Qualified Plans and IRA’s?

Answer:
Beginning in 2013, a 3.8% surtax on investment income will be assessed on high income taxpayers. The income threshold is $200,000 for single filers and $250,000 for joint filers. Withdrawals from retirement plans are excluded from the list of investment income items. Therefore, withdrawals from qualified plans and IRAs are not subject to the 3.8% surtax, but may raise overall income above the threshold amount, which could subject other (investment) income to the 3.8% tax.

Similarly, the taxable income from completing a Roth conversion is not subject to the 3.8% surtax, but also might raise overall income above the threshold. (Editor's Note: You can also CLICK HERE to watch Ed's video on what the new Health Care Law means to your taxes.)

2.

If an amount is transferred to an IRA in a direct trustee-to-trustee transfer, is there a waiting period before any of the funds can be withdrawn from the IRA without the 10% penalty?

Harvey Nusabum

Answer:
IRA-to-IRA-transfers are not subject to the one-rollover-per-year rule. Therefore, there is no waiting period to withdraw the funds. However, the 10% penalty is a separate issue.

The 10% early distribution penalty applies to distributions to IRA owners who are younger than age 59 ½ when they withdraw the funds, unless an exception to the penalty applies. Some exceptions to the penalty include disability, first home purchases, substantially equal periodic payments (also known as “72t” payments), and higher education expenses.


3.

Can a 61-year-old employee do an in-service distribution to an IRA this year with some of his 401(k) plan, leave the employer stock in the 401(k), and then next year when he retires take advantage of the NUA rule?

Diana DeCharles

Answer:
It depends on the terms of the employee’s 401(k) plan. Whether or not he can take a distribution while still working (an in-service distribution) varies from plan to plan. Assuming he can take an in-service distribution, a partial distribution of only non-company stock should be allowed. He should ask his plan administrator and get a copy of the plan’s Summary Plan Description to see what his options are. His subsequent retirement would be a new triggering event and would mean that he would become eligible again to use the NUA (net unrealized appreciation) strategy.

4.

Hello Ed,

First, I want to say I love your books and you’re one of America's best financial professionals!

My dad passed away on 2/25/12. Myself and my step-mother where beneficiaries to my dad's traditional IRA, the split was approx. 65% to my step mother and 45% to myself. By the way, she has Alzheimer's and her estranged son is now in the picture to care for her. He is making all her decision'. She also has a life estate to live in the house (it goes to me) as per the prenuptial agreement. She was never put on the deed as required. I think this is a benefit to her at this point because Medicaid can't put a value on it. I think that she will end up in an elder-care facility rather than a nursing home down the road.

My question pertains to this year’s RMD. I know that it has to be taken out because my dad passed away this year. Is there a rule on who has to take it out? I don't want to. What if my stepmother doesn't want to? Am I forced to take the full amount? Do we split it? I am 49 years old. That being said, I have already rolled over the IRA into an inherited IRA. Do I have to start taking distributions next year or can I defer them until I am of age? I know I need to revisit your books. Thanks for all the great advice!

Regards,

Paul Sofolarides

Answer:
Assuming your Dad died after his required beginning date this year, then both you and your stepmother must take your respective share of his untaken RMD (i.e., you must take 45% of it). If either you or your stepmother doesn’t take their share of the RMD, then a 50% penalty on the shortfall will apply.

We will also assume that you did not actually do a “rollover” to an inherited IRA, but that it was done as a transfer where you did not have control of the funds when they were moved to an inherited IRA. You will have to take death RMDs each year and cannot defer or wait until you are age 70 ½ because you cannot make the inherited IRA your own IRA.

-By Joe Cicchinelli and Jared Trexler

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IRAtv: 2013 Tax and Revenue Raising Provisions

Ed Slott and Company IRA Technical Consultant Jeffrey Levine details three main 2013 tax and revenue raising provisions to keep your eye on and plan for as summer flies by (we are nearly three-fourths of the way through the calendar year!)  One of those provisions is a surtax on net investment income brought on by President Obama's health care law.

View the IRAtv video below for the full report.



-By Jeff Levine and Jared Trexler

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