Slott Report Mailbag: Can IRA Distributions Make Me Susceptible to 3.8% Healthcare Surtax?

By Joe Cicchinelli, IRA Technical Expert

Follow Me on Twitter: @JoeCiccEdSlott

This week’s Slott Report Mailbag looks into two tricky areas of IRA planning. The first is how IRA distributions affect an individual’s income, and in turn, their susceptibility to the 3.8% health care surtax. We then answered a question about the equally problematic Roth IRA 5-year rules. We receive many questions on a process wrought with possible mistakes and penalties – so much so that we created an entire Roth IRA 5-Year Rules pamphlet! Do you know who knows all about the 5-year rules? An Ed Slott-trained advisor in your area.

On to the mailbag…

1. You recently said that a 401(k) distribution would add to your MAGI (modified adjusted gross income) for the purpose of determining if you are subject to the 3.8% healthcare surtax. What about Roth IRA distributions? Would they also count towards your total MAGI income for surtax purposes?

Thanks

Answer:
IRA distributions are exempt from the 3.8% surtax, but taxable distributions from IRAs can push income over the threshold amount, causing other investment income to be subject to the surtax. Because Roth IRA distributions are generally tax-free, they don’t count towards your total MAGI.

2. I have a Roth IRA that is over 5 years old, and last December I converted my Traditional IRA into a Roth IRA (paying the income tax on the non-basis amount on my 2012 tax return), then combined it with my existing Roth IRA. First, was it okay to combine them, and secondly do I have to wait for 5 years until I can withdraw the amount I had converted?

Answer:
It was okay to combine them. There are ordering rules for Roth distributions and all your Roth IRAs are considered one Roth IRA. Your contributed funds will be deemed to be the first amounts distributed. Then your conversion funds, first in, first out. If you are younger than age 59 ½ when you withdraw conversion funds within five years of the date of conversion, you’ll be assessed the 10% early distribution penalty on the amount that was taxable when you converted. The last funds out are earnings. To have a tax and penalty free distribution of earnings, the distribution must occur at least five years after the date you established your first Roth IRA and after you are age 59 ½ or dead, disabled, or for a first time home purchase.

3. We are looking to convert an IRA to a Roth IRA. We took a loss on a variable life policy that was converted to an annuity. Can we use that loss to offset the tax due on a Roth conversion?

Answer:
The conversion of the IRA to a Roth IRA is treated as ordinary income on the tax return. You can only offset that income with deductions that will offset ordinary income. You should consult with your tax preparer to see if this particular loss qualifies to offset his ordinary income.