The recent health-care legislation made quite a few changes to the Internal Revenue Code. But of all the tax rules laced throughout both the Patient Protection and Affordable Care Act, signed on March 23 by President Obama, and the Health Care and Education Reconciliation Act, approved the following week, one provision in particular has grabbed the full attention of savvy advisors: the 3.8% Medicare surtax, which applies to single filers with income exceeding $200,000 or to joint filers with income of more than $250,000.

Formally dubbed the Unearned Income Medicare Contribution, this pesky revenue-raiser doesn't kick in until 2013. But in the interim, it has sparked two important planning imperatives for high-income clients: Roth conversions and tax-free interest.

To appreciate why this is so, we must understand that the surtax will be assessed on the lesser of (1) a client's net investment income, or (2) his or her modified adjusted gross income (MAGI) in excess of the income thresholds for single and joint filers. Here, MAGI is the client's adjusted gross income plus any otherwise excluded foreign income or housing costs, according to Timothy M. Steffen, a CPA/PFS and senior vice president with Robert W. Baird & Co. in Milwaukee.

But the surtax is on "the lesser of" these two assessments, which means that if either 1 or 2 is zero, there is no surtax. Hence, a married couple with $300,000 in total salary and no investment income won't pay the tax, says CPA Robert S. Keebler, a partner at Baker Tilly Virchow Krause LLP, in Appleton, Wis. Nor will a couple pay the surtax if their only income is $250,000 of taxable interest.

Armed with this knowledge, the advisor's first task is to forecast whether the required distributions from his client's traditional IRA, which is counted in the MAGI, will trigger the surtax. You can do this by projecting out for several years the client's sources of income, Keebler says.

Suppose the couple with $250,000 in taxable interest must begin taking annual $50,000 IRA withdrawals in 2015. They will pay 3.8% on that distribution in addition to ordinary income tax, which itself could be higher than it is today. (See the accompanying chart.)

On the other hand, Roth withdrawals are not part of MAGI, so they can't trigger surtax, Steffen says. That might make Roth distributions more attractive than traditional IRAs-and makes conversions "the big opportunity to look at now," says Steffen.

Keebler agrees. "Because of the health-care bill, a lot more clients should be considering a Roth conversion," he explains. "If your client in the 35% bracket today is headed to 43.4%, a conversion will almost always make sense. Likewise for a taxpayer going from 33% now to 39.8%" starting in 2013.

Act sooner, not later. Converting the IRA this year gives the client maximum flexibility because she can choose to defer to 2011 and 2012 the taxable income created by the conversion, and thus she might pay less tax. Converting in 2013 or later comes with the risk of incurring surtax on the amount converted, Keebler cautions.

Tax-Free Becoming Freer
The other surtax-inspired opportunity lies in tax-exempt bonds. Muni interest isn't subject to the surtax and just about everything else is. Net investment income, the lone item besides MAGI that can be surtaxed, includes taxable interest, dividends, capital gains, distributions from annuities, rental and royalty income and passive-activity income, Steffen explains.

But you shouldn't wait until 2013 to consider munis for your high-bracket clients given next year's potentially higher ordinary tax rates. Taken together or individually, these changes enhance munis' allure. "The after-tax return on a taxable bond is going to be a lot lower for clients with high incomes starting in 2011," Steffen says. The question is, when will the bond market price the tax-rate changes into munis?

"To a limited degree, I suspect that rising tax rates have already been incorporated into muni-bond prices, but there is more to go," says Josh Gonze, a managing director at Thornburg Investment Management in Santa Fe, N.M., and the co-portfolio manager for the Thornburg Municipal Bond Funds. "Munis will enjoy a sizable boost in market value, relative to taxable bonds, due to the higher tax rates. I expect the impact to phase in gradually and that it won't be fully priced in until 2011," Gonze says.

But not every advisor is ready to pile into the asset class. Bob Westrick, president of WNA Wealth Advisors in Hinsdale, Ill., acknowledges that munis gain appeal when ordinary tax rates rise. "The flip side is you've got some states that are pretty much insolvent, and interest rates are more than likely going up," Westrick says. "We're taking a wait-and-see attitude, at least through the summer." It's a good reminder that the tax tail ought not wag the investment dog.

On Higher Earned Incomes, A Tax Of 0.9%
Beginning in 2013, a new 0.9% Medicare Hospital Insurance tax will apply to earned income, including self-employment income, above the same $250,000 joint/$200,000 single thresholds. Unlike other payroll taxes, this one is imposed only on employees.

Employers are not required to withhold the tax until the worker's wages exceed $200,000, Steffen says. But that can make things sticky for couples. Fast-forward to 2013 and imagine that two doctors are married to each other and each earns $200,000. Neither at that salary would have any of the new tax withheld by their employer during the year, but eventually they would be taxed for $150,000 of earned income ($400,000 minus the $250,000 threshold) and so it would show up later on their joint tax return. File this one under future administrative nightmares.

Some New Rules Already In Effect
Retroactive to January 1, the adoption credit for 2010 has been increased $1,000 to $13,170 per eligible child. And it's now refundable, says Mark
Luscombe, federal tax analyst at CCH Inc. in Riverwoods, Ill. But after 2011, this credit becomes much less generous.

Also effective now is a tax break that could help advisory shops and entrepreneurs. The small business health-care tax credit is available to small companies paying at least half the cost of health insurance for their employees (small companies in this case meaning those with fewer than 25 full-time equivalent workers). For 2010, the credit is as much as 35% of the employer-paid premiums, and it rises to 50% in 2014.

"We're looking into this for ourselves," says planner Mitchell Freedman, founder and president of MFAC Financial Advisors Inc., in Westlake Village, Calif. The primary hurdle facing Freedman's L.A.-area shop is that the average annual wages must be less than $50,000 per employee.
Fortunately, Freedman won't have to include his own salary when computing that average. Owners' salaries are specifically excluded from the calculation, observes CPA/PFS Mike Tedone, the chief compliance officer at Filomeno Wealth Management in West Hartford, Conn.

The credit is only available to businesses that actually owe tax (in other words, the credit is nonrefundable) and it phases out gradually for firms with average wages between $25,000 and $50,000 and for firms with between ten and 25 full-time equivalent employees. (Learn more at http://www.irs.gov/newsroom/article/0,,id=220809,00.html.)

Clients who qualify for the credit may be able to lower their 2010 estimated tax payments. "That's the planning opportunity," Tedone says.

Changes Affecting Clients' Benefit Plans
Under the new laws, your clients can now get tax-free, employer-provided health coverage for their children under age 27. This eradicates the previous requirement that the child must qualify as the client's dependent for tax purposes to get tax-free treatment.

Corresponding with this change, employer plans that offer coverage for dependent children must continue to make the coverage available to those children through their 26th years, Tedone says. Plans must provide this expanded coverage not later than plan years beginning on or after September 23, 2010. Further guidance is at http://www.irs.gov/newsroom/article/0,,id=222193,00.html.

This is the last year clients can get reimbursed for over-the-counter drugs from their employer's flexible spending arrangement (FSA), health reimbursement arrangement (HRA), health savings account (HSA) or Archer medical savings account (MSA) without a prescription, says Steffen. Beginning in 2011, these plans can only reimburse clients for prescribed drugs and insulin.

And come 2013, pretax contributions to health FSAs will be capped at $2,500 annually, with indexing for inflation thereafter.

Dispelling Misinformation
For some of those new rules whose effective dates are far off, the only thing advisors can do in the meantime is combat misperceptions. For instance, clients may have heard that the threshold for deducting medical expenses is scheduled to rise to 10% of adjusted gross income from its current level of 7.5%. But that's not until 2013, Steffen says, and for folks 65 and older, the threshold remains at 7.5% through 2016.
2014 is when individuals without health coverage begin paying a penalty. And it isn't until 2018 that the penalty tax will come into effect for high-cost health insurance plans-so-called "Cadillac plans."

With such long gestation periods, it's tempting to believe some provisions will be aborted before going live. Indeed, Sen. Charles Grassley, R-Iowa, is already fighting the higher medical-deduction threshold. But remember, many a pundit crowed that the estate tax would never be eliminated in 2010 despite the language in the Economic Growth and Tax Relief Reconciliation Act of 2001 saying it would. And look what happened.