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.

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