May 25, 2011

Ed Slotts IRA Advisor - April 2011 Edition

Ed Slott’s IRA Advisor
April 2011

Guest IRA Expert

Martin James, CPA
Mooresville, Indiana

Dig Deeper for True Marginal Tax Rates

Should your client convert a traditional IRA to a Roth IRA? Contribute to a traditional 401(k) or a Roth 401(k)?

Most advisors have clients weighing such questions, year after year. Often, the decision turns on marginal tax rates. The lower a client’s tax rate, the more attractive a Roth IRA conversion will be, with the promise of future tax-free income. Similarly, lower current tax rates make contributions to a Roth 401(k) more appealing because there’s less benefit to deferring tax now by contributing to a traditional 401(k).

However, marginal tax rates can’t be accurately gauged merely by looking at tax tables. There are many moving parts to consider, including phaseouts, "cliff" tax benefits, and the role of the alternative minimum tax (AMT). Sometimes the results can be surprising. A client with low or even no taxable income might have a higher marginal tax rate than someone earning six figures.

Factors that Impact the Marginal Rate

A simplified example may illustrate this. Suppose Michael Johnson is 52 years old with children aged 10 and 13. Michael has a full-time job while his wife Kim is a homemaker. If Michael contributes $22,000 to a traditional 401(k) this year, the family’s adjusted gross income (AGI) will be $100,000. The Johnsons own rental property that they actively manage. In 2011, the anticipated loss from that property is $25,000.

After taking the standard deduction and four personal exemptions, plus a $25,000 deduction from the rental property loss, the Johnsons’ taxable income would fall to $48,600. Their federal income tax for the year, taking the child tax credits into account, would be $4,444.

Now suppose that Michael calls his financial advisor to ask about a 401(k) contribution. The advisor looks at the federal income tax table for 2011 and sees that the 15% rate goes up to $69,000 on a joint return.
The Johnsons, with a projected $48,600 of taxable income, are solidly in that 15% bracket. Michael’s advisor might tell him that it makes little sense to defer tax in a traditional 401(k) in a 15% tax bracket, so he’s better off putting $22,000 into the Roth 401(k).

The reality, though, is that Michael’s marginal tax rate is much higher than 15%. That’s because of his rental property loss deduction. With AGI of $100,000 or less, up to $25,000 of passive losses from such property can be deducted, assuming other conditions are met. That deduction phases out, $1 for every $2 over $100,000, until disappearing at $150,000 of AGI.

Therefore, by funding the Roth 401(k) instead of the traditional 401(k), Michael effectively increases his family’s AGI by $33,000. That’s from $22,000 going into the Roth 401(k) plus an $11,000 reduction in the deductible loss from the rental property. Crunching the numbers, the Johnsons would have taxable income of $81,600 and a tax bill of $10,656. That’s a $6,212 increase, from switching a $22,000 contribution from the traditional 401(k) to the Roth 401(k): a 28% marginal tax rate.

Just to make matters even more complicated, the "lost" deduction is not actually lost but suspended until it can be used, perhaps when the property is sold. Therefore, the Johnsons’ intention to hold onto or sell the property also would affect the traditional 401(k) vs. Roth 401(k) decision.

Planning for Clients in Low Brackets

As mentioned, even low-bracket taxpayers can have high marginal tax rates. Advisors might not have many low-income clients but there are situations when this can arise.

Suppose, for example, that a valued client asks you to help his son Matt who is married with two young children. Matt has scant earned income while he finishes up his education. Assume that Matt has some money in a traditional IRA. He and his wife are effectively in a 10% income tax bracket, which covers taxable income up to $17,000 on a joint return this year. Therefore, you might advise Matt to convert his traditional IRA to a Roth IRA this year, at least to the extent a conversion would fill up the 10% bracket.

However, a low-income taxpayer can benefit from refundable tax credits, such as the earned income tax credit. Increasing income via a Roth IRA conversion can reduce those credits. If Matt has earned income of $30,000, in this example, his family might be entitled to a $5,000 refund. Increasing his income by $10,000 with a Roth IRA conversion would drop that refund below $2,000.

So Matt’s family stands to lose over $3,000 from a $10,000 Roth IRA conversion. That’s a marginal tax rate over 30%–a higher marginal rate than the 28% rate of a couple with $200,000 of taxable income!

Planning for Seniors

Roth IRA conversions often take place after clients are retired. At that point, tax brackets may have dropped. However, clients 65 and older typically are on Medicare. They often pay monthly premiums for Medicare Part B (doctors’ visits) and Part D (prescription drugs). High-income Medicare enrollees pay more for Parts B and D. The payments increase with income, which go up in steps rather than phase out.

For example, a new single enrollee with modified AGI (MAGI), including tax-exempt income, of $85,000 or less typically would pay $115.40 a month for Part B, or $1,385 a year. If that enrollee earns even $1 over $85,000, he’d pay $161.50 a month, or $1,938 a year.

Falling over the $85,000 cliff costs $553 a year. The same cutoff adds $144 a year to Part D costs, for a total of $697 a year. If a $10,000 Roth IRA conversion moves a client’s MAGI from, say, $85,000 to $95,000, the one-year extra $697 in premiums would add 6.97% to the tax rate on the conversion.

For married couples, the first break point is $170,000 in MAGI. If both spouses are on Medicare, a $10,000 Roth IRA conversion that takes them over the break point adds $1,394 to premiums, effectively a 13.9% surtax.

The maximum Part B premium is $369.10 a month; taxpayers who pay that much also will pay an extra $69.10 a month for Part D, for a total of $438.20 a month: $5,258 a year, or $3,873 over the standard premium cost of $1,385 per year. For married couples, the maximum excess premiums would be around $7,746 a year.

Planning for Part B and D premiums can be difficult because of the time lag. A Roth IRA conversion in 2011, for example, will result in extra MAGI on a client’s 2011 tax return, which won’t be filed until 2012. That MAGI, in turn, will be used to determine Part B and Part D premiums in 2013. Therefore, there is always a two-year delay between a MAGI-boosting action, such as a Roth IRA conversion, and its impact on Medicare costs.

These Medicare issues suggest several strategies. For instance, plan around the Medicare break points. For couples, suggest Roth IRA conversions that result in MAGI just shy of $170,000 or $214,000, for instance. Exceeding the MAGI breakpoints by even a small amount can trigger substantially higher Medicare costs.

If clients want to convert a large traditional IRA to a Roth IRA, warn them of the Parts B and D consequences. A client who converts a $500,000 IRA in 2011 may wonder why he’s paying steep Medicare premiums in 2013, unless there have been some conversations along the way.

At the same time, it may be advisable to avoid small Roth IRA conversions for Medicare enrollees. Triggering $1,850 in extra premiums might be annoying on a $50,000 conversion but that same premium increase would represent a huge chunk of a $10,000 conversion.

Required Distributions

Once clients reach age 70½, they must take required minimum distributions (RMDs) from traditional IRAs. Those RMDs will boost a client’s MAGI and may trigger extra premiums for Medicare Parts B and D. Therefore, it might make sense for clients to do some Roth IRA conversions before age 70½. If the conversions are calculated to avoid triggering higher Medicare premiums, the immediate impact can be modest and those conversions might reduce a client’s traditional IRA, reduce RMDs, and thus reduce the potential impact of RMDs on Medicare premiums.

Once clients reach age 70½ and must take RMDs, another strategy is possible, at least in 2011. Those clients can make donations directly to charity, partially or completely fulfilling RMD obligations without raising MAGI. Thus, such IRA charitable rollovers might be a valuable way to offset the impact of Roth IRA conversions on Medicare Parts B and D this year. These rollovers also may help reduce the tax on Social Security benefits for some seniors.

Alternative Minimum Tax

All the tax deductions and phaseouts and other tax wrinkles discussed above may mean little or nothing to some clients–the ones who are subject to the alternative minimum tax (AMT). Many taxpayers with AGI between $100,000 and $500,000 will owe the AMT, especially if they have multiple dependents and pay hefty amounts of state and local tax.

Taxpayers who owe the AMT must calculate AMT income (AMTI), which allows few deductions. They also have two official tax rates: 26% and 28%. An AMT exemption provides some shelter from this tax. In 2011, the exemption amounts are $48,450 (single taxpayers) and $74,450 (married couples filing joint returns). The AMT exemption phases out as AMTI increases. The phaseout begins at $112,500 of AMTI for singles and at $150,000 of AMTI for joint returns.

Therefore, single clients who are subject to the AMT will have a marginal tax rate of 26% if their AMTI is $112,500 or less. Couples in the AMT have a 26% marginal rate as long as their AMTI is $150,000 or less.

The phaseout of the AMT exemption ends with AMTI over $306,300 (singles) or $447,800 (couples) in 2011. Clients with such incomes have a 28% marginal rate. In between those thresholds, AMT payers are phasing out the AMT exemption. Their marginal tax rates are higher because they’re losing the exemption; their marginal rates are 32.5% or 35%.

Thus, clients likely to owe the AMT will be in one of four marginal tax rates–26%, 28% 32.5%, or 35%. Once you know which of those four marginal rates applies to a particular client, you’ll be able to help make knowledgeable decisions on Roth IRA conversions and 401(k) contributions.

Again, low marginal tax rates can create an ideal climate for Roth IRA conversions and Roth 401(k) contributions. The higher a client’s true marginal tax rate, the more it makes sense to defer tax via a traditional 401(k) and the less appealing a Roth IRA conversion will be.

Martin E. James, CPA/PFS, Certified Public Accountant/ Personal Financial Specialist has been assisting individuals and businesses for over 29 years with their tax, accounting and financial planning needs. A native Hoosier, Marty is a 1981 graduate of Indiana University, School of Business majoring in accounting. Marty is President of Martin James, CPA, PC, founded in 1986 and Managing Member of Martin James Investment and Tax Management, LLC, located in Mooresville, IN. Marty is a Charter Member of Ed Slott’s Master Elite IRA Advisor Group. He is listed on the website. Marty can be reached at 317-834-2276 or by email at
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Reprinted with permission of Ed Slott’s IRA Advisor
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Excerpted from Ed Slott’s IRA Advisor Newsletter
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