Please note that all of the information presented herein is for educational purposes, is general in nature, and may not be appropriate for you. It should not be relied upon or construed as financial, legal, or tax advice or recommendations. You should consult with your financial advisor for assistance in evaluating the risks and benefits of Roth conversion given your particular financial circumstances, or you are welcome to contact the author for such a consultation. Jim Dowd is a CFA charter holder and is the principal of North Capital, a fee-only registered investment advisor.
In the “Your Money Matters” column on the Fox Business website, Gail Buckner explains why the surtax on investment income resulting from the passage of the Health Care Act creates an additional reason for high income taxpayers to convert their traditional IRA’s to ROTH IRAs this year. She explains a second-order effect of this new marginal tax, related to the timing of IRA withdrawals, by using an example of two married taxpayers, each with $200,000 of assets in an IRA. One account is an ordinary IRA and the other is a Roth IRA. Both taxpayers are above age 59 1/2, so are eligible for penalty-free withdrawals. Joint income is assumed to be $170,000 per year: $70,000 in Social Security, $40,000 from a pension, and $60,000 per year in taxable interest and dividends. Under the Healthcare Act, the couple would owe income tax on $50,000 of investment income, but it would not be subject to the new 3.8% surtax because total income is less than $250,000. As the example is developed, the couple needs $125,000 to cover a major expense. If this amount were to be withdrawn from the traditional IRA, it would be taxable and the couple’s ordinary income would jump to $295,000, or $45,000 over the threshold for a married couple filing a joint return. This “excess income” would be attributed to taxable investment income and subject to the surtax. On the other hand, if the $125,000 were withdrawn from the Roth IRA, the entire amount would be tax-free. Income would remain at $170,000 and no investment surtax would apply. To the extent that a Roth conversion would have made sense for a taxpayer before the passage of the Healthcare Act, now the justification is even greater. The following example is one that I have prepared to illustrate the point. Assume that you have household salary income of $250,000, an ordinary IRA balance of $400,000, and a taxable investment account of $170,000. Long term investment returns are 8%, and interest on investments is taxed half at ordinary rates and half at capital gains rates. In this example, 100% of the taxpayer’s investment income would be subject to the Health Care Act investment surtax when it becomes effective in 2013. After a 15 year holding period, the IRA would be worth about $1.27 million before tax. Assuming that you are in the same marginal tax bracket when you begin to make withdrawals, and there is no increase in tax rates beyond what is already known, the after-tax value of the IRA would be about $666,000. The taxable investment account would grow to about $359,000 after taxes ~ including about $5,000 in Health Care Act investment taxes. Altogether, your total portfolio would be worth about $1,025,000. If you were to convert the IRA to a Roth and pay the tax this year, the $170,000 taxable account would be exhausted to satisfy the tax obligation resulting from conversion. But the $400,000 Roth would then be permanently sheltered from tax. Given the assumptions in our example, that $400,000 grows to $1.27 million, the Roth would be worth $235,000 more than the portfolio assuming no conversion. If you have questions about the numbers, try out our Roth Conversion Calculator or contact me directly. I hope to update the model soon to take account of the new Health Care Act investment surtax. In the meantime you can adjust your assumed “Future Marginal Tax Rate” to see the effect.