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2013: The year of the RMD tax bubble

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The beginning of this year marked the convergence of multiple tax changes that will have a profound effect on financial professionals and our clients. The combination of new PPACA taxes and fiscal cliff tax changes is making financial planning more difficult. As financial professionals, it is important to have a comprehensive understanding of the changes that began January 1, and how these changes could affect many of our clients.

For some, their RMD could be increasing their tax liabilities, so it’s more important than ever to pay attention to not just the amount of your clients’ wealth, but where their assets are located. The difference between a traditional IRA and a Roth could mean thousands of dollars more in taxes for your client this year and beyond.

For financial professionals, one of the most important aspects of the PPACA legislation, otherwise known as Obamacare, is the new addition of the 3.8 percent Medicare surtax. This 3.8 percent will be levied on singles with either unearned income (or investment income) over $200,000 or modified adjusted gross income (MAGI) over $200,000, whichever is less. Add $50,000 for married couples.

Adding to the complexity are the changes to tax rates in 2013 because of the fiscal cliff deal. Earned income over $400,000 will now be taxed at 39.6 percent. Additionally, income from capital gains and dividends over $400,000 will be taxed at 20 percent. 

Taxes are much higher in many ways this year compared to last year’s rates. Not only did income taxes and capital gains taxes increase for many, but so did the federal estate tax rates. Now, the Medicare surtax from Obamacare is a brand-new tax that we need to concern ourselves with going forward as well. 

The combination of these tax changes has created three distinguishable tax brackets: 15 percent, 18.8 percent and 23.8 percent. By helping your clients determine which bracket they fall in, you can help them to reduce their current and future tax liabilities. The following examples are for a single individual. For married couples filing jointly, you will need to add $50, 000 to each example.

The first bracket is made up of those who have a MAGI of $200,000 or less. The Medicare surtax and the 20 percent capital gains tax will not apply to them.

The second bracket is for those who have investment income or MAGI over $200,000 but under $400,000. They will pay 15 percent on their capital gains and dividends, and 3.8 percent on either their investment income over $200,000 or their MAGI over $200,000, whichever is less.

Those who have unearned income from capital gains and dividends over $400,000 make up the third bracket. The amount over $400,000 will be taxed at 20 percent, with the additional 3.8 percent surtax on investment income or MAGI, whichever is less.

It’s important to note the definition of unearned or investment income. Interest, capital gains, dividends, annuities, passive activity income and rental income are all considered investment income. IRA distributions, Roth conversions and distributions, municipal bonds and distributions from life insurance are not considered investment income.

IRA distributions, however, are factored into MAGI, so they can still trigger the 3.8 percent surtax if thresholds are met. This is where the bubble comes in and why it can deplete your clients nest egg at an expedited pace if not addressed now. 

A tax bubble is when someone with the higher income actually pays less in taxes than someone with lower income. Someone with income from a RMD, for example, could be paying much more in taxes than someone with income from a Roth distribution, even if the Roth-holder actually is bringing in more money annually. Whether or not someone is subject to the 3.8 percent surtax depends on where their assets are as much as how much assets they have. 

If your client, a single person, has an investment income of $200,000 and an income, including their RMD, of $125,000, his MAGI is now $325,000. The $125,000 above the threshold of $200,000 will be subject to 3.8 percent surtax, in addition to other tax obligations. This is an additional $4,750 the individual will have to pay in taxes this year, and amounts to $47,500 over a 10-year period.

Suppose a different client has a Roth IRA instead of a traditional IRA. He or she would not pay the 3.8 percent surtax because Roth income does not factor into MAGI, leaving this client with a significantly smaller tax liability because they were able to avoid the Medicare surtax.

Not only do we have to help our clients grow enough wealth to last the duration of retirement, but we also have to help them protect that wealth from excessive taxation so the money they saved in order to live comfortably in retirement will be there when they need it. 

Here are some suggestions for how you as an advisor can help your clients avoid these costly new taxes.

1. Don’t take two distributions in one year.

The IRS stipulates that a client’s first RMD must be taken the year they turn 70-and-a-half, but it can be delayed until April 1 of the following year. However, that person must take their second RMD before December 31 of the same year, essentially collecting two distributions within the same tax year. This would greatly increase their MAGI and put them in a position where they are more likely to pay that 3.8 percent surtax.

2. Consider a Roth IRA conversion.

While the best time for a client to convert their IRA to a Roth was before the fiscal cliff, a conversion could still be beneficial. The client’s income would increase this year, giving them a higher income tax liability. However, distributions from their Roth would not be subject to the 3.8 percent surtax in retirement. 

See also: Cliff deal opens the gates for Roth conversions

3. Take a look at municipal bonds.

Municipal bonds are still federally tax-exempt, and their earnings are excluded both from MAGI and investment income, allowing your client to avoid paying the 3.8 percent surtax on these investments no matter their tax bracket. These bonds can often bring in less income than other investments, but they are at least worth considering for their tax-free status.

4. Save more in retirement accounts.

For your clients who haven’t retired yet, but could be subject to this 3.8 percent tax because of their MAGI or investment income over $200,000, encourage them to save more in their pre-tax retirement accounts. This lowers their MAGI and thus makes it less likely they will have to pay the 3.8 percent now. However, come time to retire, you may be having the Roth conversion conversation.

With so many tax changes happening at once, it can be easy for advisors to feel overwhelmed and unsure how to best serve their clients. Getting a handle on the new tax laws takes some time and effort, but is well worth it in the end when your client can keep more of their hard earned money by avoiding unnecessary taxes.

For more, see:

Fiscal cliff fix brings an upside to IRAs

The advisor opportunity in tax season

In avoiding cliff, some may be over-insured


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