Under current law, higher-income taxpayers will face a 3.8%surtax on their investment income and gains. 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. This fourth part of a multi-part year-end planning article explains various retirement plan strategies for coping with the surtax and the possibility that tax rates will be higher next year
Surtax basics. Under Code Sec. 1411, for tax years 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 under Code Sec. 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income). (Code Sec.1411(d)).
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).
Higher-income employees should use designated Roth accounts if their retirement plans offer this option. A designated Roth is a separate account in a Code Sec. 401(k), Code Sec. 403(b), or Code Sec. 457 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 Code Sec. 401(k) 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, Code Sec. 401(k), Code Sec. 403(b), or Code Sec. 457 plan) as long as it's an eligible rollover distribution.