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Accounting & Tax News :: 2012 Year-end Planning: Part 4

Tax planners and their clients face the prospect of a darker tax climate in 2013 for investment income and gains. Under current law, higher-income taxpayers will face a 3.8% surtax on their investment income and gains under changes made by the Affordable Care Act. Additionally, if the EGTRRA and JGTRRA sunsets go into effect, all taxpayers will face higher taxes on investment income and gains, and the vast majority of taxpayers also will face higher rates on their ordinary income.

Reduce exposure to higher post-2012 taxes on investment income & gains:

Surtax basics


Beginning after Dec. 31, 2012, a 3.8% surtax applies to the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). MAGI is adjusted gross income (AGI) increased by the amount excluded from income as foreign earned income (net of the deductions and exclusions disallowed with respect to the foreign earned income).

Use Roth IRAs instead of traditional IRAs. The 3.8% surtax makes Roth IRAs look like a more attractive alternative for higher-income individuals. Qualified distributions from Roth IRAs are tax-free and thus won’t be included in MAGI and won’t be included in net investment income. By contrast, distributions from regular IRAs (except to the extent of after-tax contributions) will be included in MAGI.

A qualified distribution from a Roth IRA is one made: (a) after five years (measured from January 1 of the year for which the taxpayer first made any Roth IRA contributions to any Roth IRA, including rollover or conversion contributions, to the last day of the fifth year); and (b) on or after he attains age 59 1/2; because of death or disability; or to buy, build, or rebuild the taxpayer’s first principal residence. As a bonus, Roth IRA owners do not have to take required minimum distributions (RMDs) during their lifetimes (Roth beneficiaries must, however, take required distributions from the account).

recommendation: Higher-income employees should use designated Roth accounts if their retirement plans offer this option. A designated Roth is a separate account in a plan to which an employer allocates an employee’s designated Roth contributions and their gains and losses. Instead of making elective, pre-tax contributions to his regular account, the employee directs that part or all of the contribution be made to a nondeductible designated Roth account within the plan. When a designated Roth account is set up within a plan, it’s called a Roth 401(k). Note that unlike regular Roths, where contributions can’t be made by higher-income individuals, there is no income limitation on annual contributions to a designated Roth. Workers of all income levels are eligible to contribute to such retirement accounts.

Make a rollover to a Roth IRA this year rather than the next. Taxpayers who are thinking of rolling over regular IRAs to Roth IRAs should do so before 2013 to avoid winding up with higher MAGI as a result of the rollover and potentially exposing unearned income to the 3.8% surtax. Keep in mind that a Roth IRA can accept rollovers from an employer-sponsored plan (e.g., profit-sharing),as long as it’s an eligible rollover distribution.

caution: Conversions should be approached with care because they will increase your AGI for 2012. Also, if a taxpayer made a traditional IRA to Roth IRA conversion in 2010, and chose to pay half the tax on the conversion in 2011 and the other half in 2012, making another conversion this year could expose the taxpayer to a much higher tax bracket.

Tax planning for required minimum distributions. For 3.8% surtax purposes, investment income doesn’t include distributions from tax-favored retirement plans, such as qualified employer plans and IRAs. However, MAGI does include taxable distributions from qualified employer plans and IRAs. As a result, taxpayers nearing their MAGI threshold, or who already exceed their MAGI threshold because of other income, should carefully plan their distributions from qualified plans or IRAs in order to avoid or minimize exposure to the 3.8% surtax. Of course, RMDs must be taken when a taxpayer attains age 70 1/2.

Taxpayers who attain age 70 1/2 in 2012 have until their required beginning date of Apr. 1, 2013, to begin making RMDs from their IRAs. As a general rule, they also must begin RMDs from their qualified retirement plan accounts by that date (non-5% company owners who continue working may, however, defer RMDs until April 1 following the year they retire)

In general, the first distribution year is the year in which the IRA or qualified plan account owner attains age 70 1/2. The taxpayer may postpone the first year’s RMD until the second distribution year (i.e., make the first-year RMD by April 1 of the second year). However, taking advantage of the three-month “grace period” does not absolve the taxpayer from making an RMD for the second distribution year.

illustration : Betty Fox, a widow, celebrated her 70th birthday on Mar. 1, 2012, and thus will attain age 70 1/2 this year. She is the owner of a traditional IRA that had a value of $1,000,000 on Dec. 31, 2011. Her RMD for 2012, the first distribution year, is $36,496 ($1,000,000 divided by 27.4, the factor from the Uniform Table in , Q&A 2 for an individual who is 70, Betty’s age at her birthday in 2012). However, Betty may delay taking this distribution until as late as Apr. 1, 2013, but even if she does, she must still take a RMD for 2013.

Assume that Betty does not take the first distribution in 2012, and the value of her IRA is $1,050,000 on Dec. 31, 2012. Her required minimum distribution for 2013 is $39,623 ($1,050,000 divided by 26.5, the factor from the Uniform Table for an individual who is 71). By delaying taking her first distribution until 2013, Betty must take a total distribution of $76,119 that year ($36,496 for the 2012 RMD, and $39,623 for the 2013 RMD).

Delaying taking the first year’s RMD until the second distribution year could have one or more of the following effects:

(1) Taking double distributions in 2013 could result in the taxpayer’s exceeding the surtax’s MAGI-based threshold and exposing unearned income to a higher tax bill.

(2) Even if the taxpayer’s MAGI doesn’t approach the surtax threshold, all or part of the first distribution may be taxed at a higher rate than it would be if it was distributed in the first year. This may be the result whether or not the Bush-era sunsets go into effect at the end of 2012. If tax brackets remain more or less the same next year, taking double distributions in 2013 could cause part or all of the distribution to be taxed at a higher bracket.

(3) More of the distributee’s Social Security benefits may be subject to tax.

(4) The resulting increase in the distributee’s AGI for the second distribution year may cause a reduction in deductions and/or credits subject to an AGI floor, such as the deduction for medical expenses.

caution: There are some situations when it will be advisable for an individual who attains age 70 1/2 this year to delay taking the first (2012) distribution from a traditional IRA or a qualified plan until 2013. For example, the taxpayer’s MAGI is much lower than the surtax’s income threshold and he expects to be in a much lower tax bracket next year (e.g., because he’s retiring this year).


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