The 3.8 Percent Medicare Surtax in Retirement Income Planning

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1 Reprinted with permission from the Society of FSP. Reproduction prohibited without publisher's written permission. The 3.8 Percent Medicare Surtax in by Lynn A. Nolan, CLU, ChFC, CASL, RICP Abstract: In 2012, the United States Supreme Court upheld the proposed tax increases as part of the Patient Protection and Affordable Care Act of As a result, the new 3.8 percent Medicare surtax, which is intended to raise revenue to pay for health care reform, took effect in This new tax, combined with tax implications as a result of the American Tax Relief Act of 2012, poses major income planning needs for wealthier clients at or near retirement. This issue of the Journal went to press in December Copyright 2014, Society of Financial Service Professionals. All rights reserved. Tax Implications for Wealthy Clients lients with higher incomes will be feeling the burden of both the American Tax Relief Act C (ATRA) and the new Medicare surtax. ATRA increased the top federal income tax rates for individuals to 39.6 percent. This, combined with the higher tax rates for qualified dividends and capital gains, which was raised to 20 percent, already poses challenges for this group. Now, with the addition of the Medicare surtax as a result of health care reform, wealthier clients will need proper planning in order to ease some of the tax burden. Overview of the Medicare Surtax The 3.8 percent Medicare surtax 1 has no cap and it applies to all net investment income (NII) for clients with a modified adjusted gross income (MAGI) 2 above a threshold amount. For single taxpayers, the income threshold is $200,000; for married individuals filing separately, the threshold is $125,000; and for married couples filing jointly, it is $250, The income thresholds are not indexed for inflation. The increased tax also applies to trust income that is not distributed to beneficiaries in excess of $12, NII that is subject to the tax includes interest, royalties and rent, dividends, passive activity income, 5 capital gains, and taxable annuity distributions. Example: Income Subject to Medicare Tax As you can see from the example in Table 1, Ben and Sally have income from sources that are subject to the 3.8 percent Medicare surtax. The result is an additional tax of $6,460. The items listed in bullets are not considered when 72

2 determining NII: Cash Value Accumulation, Death Benefits, and for Non-MEC Life Insurance Policies, Withdrawals up to Cost Basis and Loans 6,* Deferred Annuity Growth Distributions from IRAs or Qualified Plans Wages and Self-Employment Income Municipal Bond Interest Social Security and Veterans Benefits Gains from the Sale of an Active Interest in a Partnership or S Corporation Net Gain on the Sale of a Primary Residence Not Exceeding $250,000 (Single), $500,000 (Married) 7 Active Trade or Business Income (including interest dividends, capital gains) Charitable Trusts Example: Income Not Subject to Medicare Tax Even though John and Mary (Table 2) have more income than Ben and Sally, they are not subject to the Medicare surtax because their income came from sources that are not considered when calculating NII. Additional Tax Considerations ATRA also resurrected the pre-2001 maximum tax rate of 39.6 percent for single individuals with incomes over $406,750, and for married couples with incomes over $457,600. All other income tax brackets remain the same. The 39.6 percent tax bracket also applies to trusts and estates with income above $12, Couple the 39.6 percent income tax bracket with a possible 3.8 percent Medicare surtax on NII, and a client can face 43.4 percent in federal taxes. Long-term capital gains and dividend tax rates also increased from 15 percent to 20 percent under ATRA for single filers with taxable incomes over $406,750 and for married filers with taxable incomes over $457,600. In addition, the Patient Protection and Affordable Care Act created an additional Medicare contribution tax (known as the Hospital Insurance Tax) equal to 0.9 percent of wages for single employees or self-employed individuals with wages exceeding $200,000; $125,000 for married individuals filing separately; and $250,000 for married workers filing jointly. 9 Clearly, income tax planning for retirement will be paramount to these taxpayers. Strategies to Mitigate the 3.8 Percent Medicare Surtax There are numerous strategies that can be utilized for clients to build an asset mix that includes tax-deferred, taxable, and tax-exempt assets. TABLE 1 Income Subject to Medicare Surtax Ben and Sally (Married Filing Jointly) Income from Wages $240,000 Other Income Interest $20,000 Dividends $60,000 Gain from Sale of Investments $100,000 NET INVESTMENT INCOME $180,000 Wages plus NII $240,000 + $180,000 = MAGI $420, % Income Threshold $250,000 MAGI minus Threshold $420,000 - $250,000 NII Subject to Medicare Surtax = $170, % of $170,000 = Total Medicare Tax Due $6,460 TABLE 2 Income Not Subject to Medicare Tax John and Mary (Married Filing Jointly) Income from Social Security, $325,000 IRAs and Pensions Other Income: Life Insurance Cash Withdrawal $150,000 of Cost Basis Gain from Sale of $300,000 Principal Residence Municipal Bond Interest $40,000 NET INVESTMENT INCOME $0 MAGI $325,000 Income Threshold Under the threshold Taxable Amount NOT subject to the 3.8% tax, regardless of income since there is no Net Investment Income Total Medicare Surtax Due $0 73

3 Income Tax Diversification The concept of tax diversification works in a similar way to diversifying investments into different asset classes to mitigate the risk of substantial loss in retirement portfolios. Where tax rates will be in the future and the shape of future tax policies is uncertain, so it is prudent to place assets into accounts according to their tax treatment. This approach can reduce taxation by providing retirees alternatives to spend down retirement savings with the least amount of tax expense under the prevailing tax law. Essentially, a properly diversified portfolio from a tax perspective will generally reduce retirees tax liability during their retirement years. 10 Therefore, a mix of tax-deferred, taxable, and tax-exempt investments should be considered. Funding Employer-Sponsored Retirement Plans One way to reduce the 3.8 percent Medicare surtax on NII in a current year is for workers to reduce MAGI by contributing salary deferrals to a 401(k), 403(b), 457(b), or SIMPLE IRA account. Business owners who continue to draw salary in retirement will also benefit from this strategy. In 401(k) plans that offer a Roth account, clients whose incomes exceed the limit for a Roth IRA contribution have the opportunity to build potentially incometax-free money in the plan. The salary deferral limit for 2014 is $17,500 plus an additional $5,500 if the client is age 50 or older. 11 Upon a triggering event such as retirement, the Roth account can be rolled to a Roth IRA, providing a source of retirement income that will not increase MAGI. Deferred-Compensation Plans Under certain circumstances, a nonqualified deferred-compensation plan can provide an opportunity to reduce MAGI. For example, in a small business operating as a C corporation the owners may want to establish a nonqualified deferred-compensation plan (particularly where the corporation is in a lower income tax bracket than the owner). Deferred-compensation plans can also provide opportunities for key executives who are nonowners to defer significant income in order to save for retirement and reduce current MAGI. In a passthrough entity, deferred-compensation plans are less appealing since the owners are taxed on current profits of the business whether they receive the income or not. Nonqualified Deferred Annuities A client can control the timing of income recognition by acquiring a deferred annuity and keeping it in the deferral phase until his or her MAGI is below the 3.8 percent tax threshold. The gain will grow tax-deferred. If a withdrawal is made during the deferral phase, gain is taxed first, followed by a tax-free recovery of cost basis. Once the deferral phase ends and the annuitization (or payout) phase begins, each payment will be treated as part cost basis and part gain, calculated using an exclusion ratio. 12 Immediate Annuities Annuitization provides a known and guaranteed income stream that can be incorporated into retirement income and tax planning. Single Premium Immediate Annuities (SPIAs) that are funded with after-tax assets are considered nonqualified and have the advantage of an exclusion ratio whereby part of each payment will be tax-free. 13 Qualified or IRA SPIAs will be subject to ordinary income tax. Municipal Bonds To manage the impact of the Medicare surtax, clients may want to add or increase tax-exempt bond investments, as they will not produce or increase either NII or MAGI. This asset may also be a suitable investment for a trust wishing to retain income. Charitable Trusts A Charitable Remainder Trust (CRT) is a split-interest trust consisting of an income interest and a remainder interest. During the term of the trust, the income interest is usually paid out to the donor or some other noncharitable beneficiary. At the end of the trust term, the remainder (whatever is left in the trust) is paid to a charity or charities that have been designated in the trust document. For the charitably inclined, one benefit of this strategy is to level NII over a longer period of time so as to keep MAGI below the threshold amount. 14 A Charitable Lead Trust (CLT) is also a split-interest trust consisting of an income interest and a remainder interest. During the term of the trust, the income 74

4 interest is paid out to a named charity. At the end of the trust term, the remainder is paid to noncharitable beneficiaries (e.g., children of the donor). The advantage of this strategy is to offset NII against charitable deductions dollar for dollar in a tax-efficient manner. 15 Life Insurance Cash value whole life, universal life, indexed universal life, variable life, and survivorship life insurance policies grow income-tax-deferred. In addition to an incometax-free death benefit, withdrawals of cash value and loans, up to the basis in the contract, will not be subject to NII or income tax, provided the policy is not a modified endowment contract. 16 Insurable taxpayers with a need for life insurance will find it a tax-favored retirement income solution and a perfect strategy to lessen their exposure to the Medicare surtax. Roth Conversion Roth Accounts 17 ATRA 18 expanded the ability of individuals to convert pretax balances in 401(k) plans into designated Roth accounts without a qualifying trigger event such as separation from service. Ordinary income tax on the conversion will be paid with monies from outside the plan and the 10 percent penalty for individuals under age does not apply. 19 However, the ability to change one s mind and recharacterize the account back to pretax money is not available. 20 Qualified distributions from Roth accounts are income tax free 21 and therefore will not be included in MAGI, nor in NII for purposes of the 3.8 percent Medicare surtax. Convert Traditional, SEP, and SIMPLE 22 IRAs to a Roth IRA As an additional benefit, Roth IRA owners do not have to take any required minimum distributions (RMDs) from their accounts during their lifetimes (although account beneficiaries must do so after the death of the owner). In order to determine whether or not a Roth conversion makes financial sense, a financial analysis should compare the income tax rate applicable to the conversion with the expected tax rate on future distributions from the retirement account. Spreading out conversions over a number of years may make sense for many individuals. Funds that would be exposed to the higher taxes under ATRA and the 3.8 percent Medicare surtax could be used to pay the tax on the conversion. Wealthy children may wish to make gifts to parents to enable the parents to convert their IRAs to Roth IRAs. Also, more funds may accumulate in a Roth IRA for that child who ultimately inherits the account, since no RMDs have to be taken by the Roth IRA owners. Another strategy to consider is for parents or grandparents to make gifts to the younger generation. For exam- TABLE 3 Roth Conversion to Reduce 3.8% Surtax in Retirement* No Conversion Betty, age 71 and single, has $150,000 of NII per year and traditional IRA distributions of $250,000 per year. If Betty keeps everything in her traditional IRA, Betty s NII for 2014 and subsequent years will be $150,000 and her MAGI will be $400,000. Therefore, Betty will pay the 3.8% Medicare surtax on $150,000 [i.e., lesser of $150,000 NII or $200,000 of MAGI ($400,000) over the threshold amount of $200,000] each year during retirement. ROTH Conversion On the other hand, if Betty converts most of her traditional IRA to a Roth IRA in 2014, she would pay the 3.8% Medicare surtax in 2014 only on the $150,000 of NII using monies from other accounts. Every year going forward, Betty would take traditional IRA distributions up to the threshold amount (i.e., $50,000 of traditional IRA distributions) and take Roth IRA distributions for the rest. Thus, none of Betty s $150,000 NII each year would be subject to the 3.8% Medicare surtax. This would save Betty $5,700 in taxes each year. *Example provided by Stephen J. Bigge, CPA, CSEP Keebler & Associates, LLP 75

5 TABLE 4 Roth Conversion for Wealth Transfer* In 2014, Paul, age 60 and married, retired from his company, whereby he will be receiving a pension and deferred compensation of $400,000 per year for the next 20 years. Paul s retirement accounts consist of $3,000,000 in a 401(k) plan (which Paul will be rolling over to a traditional IRA in 2014) and $5,000,000 in a taxable investment account. Paul has determined that he and his wife need about $200,000 per year after-tax to live on throughout retirement, so the pension and deferred-compensation payments (along with Social Security) will be more than enough to cover their annual cash flow needs for the next 20 years. After the pension and deferred compensation payments end in 20 years, Paul expects that the interest and dividends from his taxable investment account and a small portion of the RMDs from his traditional IRA (along with Social Security) will be adequate to meet Paul and his wife s annual after-tax cash flow needs. Therefore, most of the 401(k) plan (which will be in a traditional IRA by the end of 2014) will not be needed for retirement. Given the above, Paul s accountant determined that Paul should convert $1,500,000 of his 401(k) plan to a Roth IRA and that Paul should use a portion of his taxable investment account to pay the income tax on the conversion. Paul s accountant determined that, on a marginal basis, the future RMDs on the $1,500,000 being converted would likely be taxed at a 39.6% income tax rate (if not higher). Assuming a $1,500,000 Roth IRA conversion, a 39.6% income tax rate on the conversion, a 39.6% income tax rate on traditional IRA distributions throughout retirement, a pretax rate of return of 6% (on the traditional IRA/Roth IRA), and an aftertax rate of return of 4.5% (on the taxable investment account): By converting half of the 401(k) balance to a Roth IRA, Paul substantially reduces the amount of RMDs required from the traditional IRA, which also lowers his ordinary income tax liability. In addition, this strategy lets the Roth IRA grow tax free during his lifetime and leaves a much greater inheritance to his children and grandchildren. Unless tax law changes, the next generation will be able to do an inherited/ stretch Roth IRA 23 with the proceeds. Because Paul and his wife will likely be subject to estate tax in the future, Paul should consider naming a bypass trust as beneficiary of the Roth account. If a bypass trust is used, the oldest named beneficiary in the look-through 24 trust is generally used to calculate RMD. A Roth IRA provides much more tax-efficient funding than a traditional IRA, particularly for a trust. This is due to the fact that a portion of a traditional IRA will be lost to income taxes while the entire Roth IRA can potentially pass and continue growing income tax free. 25 The table below shows the benefit of converting to a Roth IRA in SCENARIO 1 - No Conversion SCENARIO 2 - Roth IRA Conversion Taxable Taxable Traditional Investment Investment % IRA Account TOTAL Roth IRA Account TOTAL Difference Difference Gross Assets - Initial Year $1,500,000 $594,000 $2,094,000 $1,500,000 $594,000 $2,094,000 Less: Income Tax (594,000) - (594,000) - (594,000) (594,000) Net Assets - Initial Year $906,000 $594,000 $1,500,000 $1,500,000 $ - $1,500,000 $ % Gross Assets - Year 10 $2,686,272 $922,464 $3,608,735 $2,686,272 $ - $2,686,272 Less: Income Tax (1,063,764) - (1,063,764) Net Assets - Year 10 $1,622,508 $922,464 $2,544,972 $2,686,272 $ - $2,686,272 $141, % Gross Assets - Year 20 $4,810,703 $1,432,558 $6,243,261 $4,810,703 $ - $4,810,703 Less: Income Tax (1,905,038) - (1,905,038) Net Assets - Year 20 $2,905,665 $1,432,558 $4,338,223 $4,810,703 $ - $4,810,703 $472, % Gross Assets - Year 30 $8,615,237 $2,224,719 $10,839,956 $8,615,237 $ - $8,615,237 Less: Income Tax (3,411,634) - (3,411,634) Net Assets - Year 30 $5,203,603 $2,224,719 $7,428,322 $8,615,237 $ - $8,615,237 $1,186, % ASSUMPTIONS Income Tax Rate on Roth IRA Conversion 39.60% Income Tax Rate on Traditional IRA Distributions 39.60% Pretax Rate of Return (Traditional IRA/Roth IRA) 6.00% After-Tax Rate of Return (Taxable Investment Account) 4.5% For the sake of simplicity, the entire amount of the RMD (on the other $3,000,000 traditional IRA) is assumed to be taken out of the portion that is not converted. *Example provided by Stephen J. Bigge, CPA, CSEP Keebler & Associates, LLP 76

6 ple, consider the 75-year-old client who has a 40-year-old child with a traditional IRA. The parent could gift the child enough cash to pay the income tax on a Roth conversion. Now the child (perhaps a future high-income earner) will have a Roth IRA, free of the RMD rules, and will be less likely to owe the Medicare surtax someday. The examples in Tables 3 and 4 show the power of the Roth conversion in retirement. Conclusion The 3.8 percent Medicare surtax is in place and taxpayers will see the reality of this new tax for years to come. This tax, in addition to tax implications from ATRA, will have a significant impact on wealthier clients. They need to be made aware of this new tax and begin modifying their current portfolios to put them in a more tax-efficient position in their retirement years. *Editor s note: After publication of the article, this point was reworded here for clarification at the author s request. Lynn Nolan, CLU, ChFC, CASL, RICP, is the Director of Retirement Planning Services at The Penn Mutual Life Insurance Company, providing sales and technical support in the areas of ERISA qualified retirement plans, SIMPLE, SEP, Traditional IRAs, ROTH IRAs, and Nonqualified Annuities. Lynn is a graduate of The Pennsylvania State University with a BA degree in speech communications. She holds a Pennsylvania Life & Annuity insurance license, and Series 6 & 63 registrations with FINRA. Lynn is a member of the American Council of Life Insurers (ACLI) Retirement Plans Committee, Society of Financial Service Professionals, American Society of Pension Plan Actuaries (ASPPA), and is currently president of the National Pension Directors Association. She can be reached at (1) View the IRS s questions and answers at (2) MAGI is adjusted gross income (AGI) increased by net foreign-source income exempt from regular tax under Code Sec. 911(a)(1). For most taxpayers it is generally the amount reported on line 37 of Form (3) IRC Sec. 1411(a)(2). (4) Cost of living inflation adjusted for (5) IRC Sec. 469 and IRC 475(e)(2). (6) IRC Sec. 7702A. (7) Joint Committee on Taxation, Technical Explanation (JCX-18-10), at 135. (8) Cost of living inflation adjusted for The 39.6 percent tax rate also applies to those married filing separately with incomes over $228,800, and those filing as head of household with incomes over $432,200. (9) The FICA tax is 1.45% for both employers and employees. The Patient Protection and Affordable Care Act adds 0.9% to the employee portion for individuals earning more than $200,000 per year and married couples earning more than $250,000 per year. The 0.9% Hospital Insurance Tax is not deductible by the self-employed. Not subject to COLA. (10) Gordon M. Silver, Tax Diversification in Retirement Planning, Journal of Financial Service Professionals 67, no.1 (2013): (11) IRC Sec. 402(g) provides limits for salary deferrals, adjusted for cost of living annually. (12) IRC Sec. 72(b)(2). (13) IRC Sec. 72(a); Treas. Reg (14) Keebler and Associates. Presentation by Bob Keebler at the LIMRA Advanced Sales Conference, August 7, (15) Ibid. (16) IRC Sec. 7702A. (17) Kenneth Anderson and David S. Hulse, In-Plan Rollovers from Traditional 401(k), 403(b), and 457(b) Plans to Roth Accounts: A Decision Framework, Journal of Financial Service Professionals 67, no. 5 (2013): (18) American Taxpayer Relief Act of 2012 (P.L , H.R. 8, 112th Cong., 2d Sess.) expanded IRC 402(A)(c)(4). (19) Ibid. (20) Ibid. (21) Ibid. (22) IRC Secs. 408(d)(3)(G), 408A(a); Treas. Reg A-4, A-4. (23) IRC Sec. 408(a)(6). (24) Treas. Regs 1.401(a)(9)-4, A-5(b), 1.401(a)(9)-4, A-3. The following must be met 1) the trust must be valid under state law, 2) the trust must be irrevocable, 3) the beneficiaries must be identifiable in the trust document, 4) the trust document must be received by the custodian/trustee of the qualified account by October 31 of the year after the year of death, and 5) the beneficiaries must be human beings. (25) April Caudill, Roth Conversion Strategies for Beneficiaries, Journal of Financial Service Professionals 64, no. 4 (2010):

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