If you’ve been bitten by the net investment income tax (NIIT) in the past three years, you may now be ready to explore strategies that avoid or reduce your exposure. This surtax can affect anyone with consistently high income or with a big one-time shot of income or gain.
NIIT Basics – Are you exposed?
Let’s review the basics of the NIIT. Congress passed the 3.8% Medicare surtax on investment income in 2012 to help pay for the Affordable Care Act. The surtax became effective for tax years beginning after December 31, 2012. The NIIT affects taxpayers with modified adjusted gross income (MAGI) above $200,000 for a single person, above $250,000 for a couple, and above $125,000 for a married person filing separately. (MAGI is generally the last number on page 1 of your Form 1040 – your gross income less certain allowable deductions.) Notably, a marriage penalty is built into this surtax and the surtax threshold levels are not indexed for inflation going forward.
The amount of net investment income subject to the NIIT is the lesser of (1) your net investment income or (2) the amount by which MAGI exceeds the threshold discussed above.
What income is subject to the NIIT? Generally net investment income includes the following:
- Annuity distributions
- Income from businesses that are reported on your tax return as “passive activities”
- Net gains from the disposition of property.
Plan now to minimize the bite of the NIIT in 2016 and succeeding years
Strategies to Reduce Your Net Investment Income:
- Sell securities with losses before year-end to offset gains during the year from the sale of securities.
- Donate appreciated securities instead of cash to IRS-approved charities so that gains won’t be included on your return even though you will receive a tax deduction for the donation.
- Use installment sales or Section 1031 like-kind exchanges to either spread the gain recognition over several years or defer the gain on the sale of property. These two strategies work best for investment real estate.
Strategies to Reduce Your Modified Adjusted Gross Income:
- Invest more taxable investment funds in municipal bonds. Interest income from municipal bonds is federally tax exempt and also state exempt if bonds are issued by your resident state. If you are subject to the NIIT, be sure to include the 3.8% in your municipal bond interest conversion calculation.
- Invest taxable investment funds in growth stocks. Gains won’t be taxed until the stocks are sold. Growth stocks generally do not distribute dividends.
- Consider conversion of traditional IRA accounts to ROTH accounts. This idea is part of a long-term strategy and requires careful coordination with your tax and investment advisors. The taxable income from the conversion will increase your MAGI and may result in more of your investment income being subject to the NIIT in the year of the ROTH conversion. In the future, though, this strategy could result in tax savings since the earnings and gains inside the ROTH will be exempt from both income tax and the NIIT when distributed.
- Invest in life insurance and tax-deferred annuity products. Earnings from life insurance contracts and annuity contracts generally aren’t taxed until they are withdrawn. Life insurance death benefits are generally exempt from federal income tax.
- Invest in rental real estate. Rental income is offset by depreciation deductions, reducing the amount of NII and MAGI.
- Maximize deductible contributions to tax-favored retirement accounts such as 401(k) and self-employed SEP accounts.
- If you are a cash basis self-employed individual or sole shareholder of an S Corporation, consider accelerating business deductions into 2016 and deferral of business income into 2017.
As you can see, higher income taxpayers with investment income have some planning options when it comes to limiting the impact of the surtax, but in many cases, there may not be a way to avoid it. Bottom line? The NIIT is complex and all strategies should be discussed with your tax and investment advisors before implementation to avoid other unintended tax consequences.