Key Takeaways
- The IRS’s 3.8% net investment income tax falls on the lesser of investment income or modified AGI above $250,000 for a married couple filing jointly.
- A Roth conversion isn’t investment income, but it raises modified AGI, and that can pull dividends and interest into the tax.
- A hypothetical couple with $230,000 of modified AGI, $40,000 of it dividends and interest, who convert $50,000 owe $1,140 of this tax on top of the regular tax on the conversion.
- Converting $20,000 instead keeps them at the $250,000 line and out of the tax, and spreading conversions across several years is one way to do it.
Taylor Schulte, host of the Stay Wealthy Retirement Podcast, walked through a sneaky one on this week’s episode. The timing fits, since plenty of retirees are planning their year-end Roth conversions right now.
His example is a hypothetical married couple with $230,000 of modified adjusted gross income, $40,000 of it from dividends and interest. They convert $50,000 from a traditional IRA to a Roth IRA at year end. They expect the regular income tax on that $50,000.
What they probably don’t expect is another $1,140 bill from a tax that doesn’t even apply to the conversion.
6 safe dividend stocks paying retirees 6%+ yields
There are over 100 stocks paying 6%+ annual dividends today.
But after an extensive investment review leveraging TIKR’s proprietary data, we now believe only six of them are truly safe for retirees.
They’re all yours for free as part of our new investment report, which you can access right here.
The 3.8% tax that keys off your income
The tax is the net investment income tax. According to the IRS, it’s a 3.8% tax on net investment income for people whose modified AGI is over a set line. Those lines are $250,000 for a married couple filing jointly or a qualifying surviving spouse, $200,000 for single filers and heads of household, and $125,000 for married couples filing separately. Schulte listed what it hits: interest, dividends, capital gains and certain rental income.
The important part is the amount the 3.8% is charged on. For an individual, the IRS charges it on the lesser of two figures: net investment income, or modified AGI above the line.
A Roth conversion doesn’t count as investment income, so the 3.8% never touches the converted dollars themselves. But as Schulte explained, conversions and IRA withdrawals “do increase your modified adjusted gross income, which can cause some of your other investment income to become subject to it.”
How $50,000 becomes $1,140
Here’s the couple’s math, step by step:
- Before the conversion, their modified AGI is $230,000. That’s $20,000 under the $250,000 line, so their $40,000 of dividends and interest goes untouched.
- The $50,000 conversion takes them to $280,000, which is $30,000 over the line.
- The tax falls on the lesser of their $40,000 of investment income or the $30,000 excess. That’s $30,000.
- 3.8% of $30,000 is $1,140.
So the conversion pulls $30,000 of dividends and interest into a tax the couple wasn’t paying before.
The lesser-of rule also puts a ceiling on it. Every $1,000 of income past the line costs this couple another $38, but only until the excess reaches their $40,000 of investment income. After that, the most this tax can cost them is $1,520 (3.8% of $40,000), however much they convert.
Compare the couple’s options:
| Conversion | Modified AGI | Over the $250,000 line | Amount taxed at 3.8% | Net investment income tax |
|---|---|---|---|---|
| None | $230,000 | $0 | $0 | $0 |
| $20,000 | $250,000 | $0 | $0 | $0 |
| $50,000 | $280,000 | $30,000 | $30,000 | $1,140 |
All of this sits on top of the regular income tax the conversion brings. Schulte said it plainly: “The true tax cost of a conversion can be higher than your federal income tax bracket alone would suggest.”
Room under the line is free
The simplest move is sizing the conversion to the room left. This couple has $20,000 between $230,000 and the $250,000 line. A $20,000 conversion leaves nothing over the line, so there’s nothing for the 3.8% to fall on.
The rest can wait for another year. Schulte said this is “another reason we often recommend spreading Roth conversions across several years instead of completing one large conversion all at once.” Each year’s conversion is measured against that year’s income, so a few smaller conversions can each stay under the line where one big one wouldn’t.
The investment-income side matters too, because the tax falls on the smaller of the two figures. If this couple’s dividends and interest had come to less than $30,000, the 3.8% would have fallen on that smaller amount instead.
The same mechanics apply to a single filer, with the line at $200,000.
The line doesn’t move
The thresholds are a fixed dollar line in the law. Schulte noted they “have not changed since the tax was introduced in 2013, meaning more and more households are becoming subject to it over time.” If your income keeps creeping up, a conversion that fit under the line a few years ago may not fit this year.
What would change the answer for this couple is a year with less income, or less investment income, which opens more room under the line.
My take: $1,140 shouldn’t talk anyone out of a conversion that makes sense. But if your income sits within shouting distance of the line, check how much room you have first. Converting up to the line costs you nothing in this tax, and every dollar past it costs you 3.8 cents.
Enjoy your retirement in style with these safe 6%+ dividend yields
Dividends can hold the key to enormous wealth. But only if you buy the right ones.
Picking the right high-yield dividend stock can be the difference between a dream retirement…and scraping by every month, waiting for the next Social Security check to clear.
We’ve identified six stocks yielding 6%+ that we believe every retiree should know about right now.
Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. Our analysis might not include recent company news or important updates. TIKR has no position in any of the stocks mentioned. Thank you for reading, and happy investing!
