Strategies for minimizing the net investment income tax

For high-income earners, taxes are higher this year than they’ve been in a long time. In addition to higher tax rates on ordinary income, capital gains and dividend, many taxpayers are now subject to a 3.8 percent Medicare surtax on net investment income (the “NII tax”). If the NII tax applies to you, be sure to incorporate it into your tax planning. There may be strategies you can employ to reduce or even eliminate the tax.

Does the tax apply to you?

Taxable net investment income includes interest, dividends, annuities, royalties and rents (unless the income is derived from an active trade or business), less allocable deductions. It also includes income from passive activities — such as rental real estate — and income from businesses trading in financial instruments or commodities. It does not include distributions from IRAs and qualified retirement plans.

The NII tax applies to taxpayers whose modified adjusted gross income (MAGI) exceeds the following thresholds:

  • Single filer: $200,000
  • Joint filer: $250,000
  • Married filing separately: $125,000
  • Head of household: $200,000

Generally, your MAGI is equal to your adjusted gross income unless you live abroad and have foreign-earned income, which may make it a bit higher. The NII tax applies to the lesser of your net investment income or the amount by which your MAGI exceeds the threshold. For example, if you’re a joint filer with $300,000 in MAGI and $75,000 in net investment income, you’re subject to NII tax on $50,000, the amount by which your MAGI exceeds the $250,000 threshold.

How can you reduce the tax?

If you determine that the tax does apply to you, consider incorporating the following strategies to reduce or eliminate it.

Reduce your MAGI.

The first approach allows you to limit the amount of net investment income that’s subject to tax or, if you can bring your MAGI below the threshold, eliminate NII taxes altogether.

Strategies for reducing current income include maximizing contributions to IRAs and qualified retirement plans and participating in nonqualified deferred compensation plans. (For more on nonqualified deferred compensation, visit http://www.rehmann.com/nonqualified.)

Reduce your investment income.

Strategies for reducing your net investment income include: Maximizing retirement plan contributions. As noted above, maximizing contributions to IRAs and qualified retirement plans reduces your MAGI. It can also help reduce NII taxes during retirement because distributions from these plans are not included in net investment income (although they do count toward the MAGI threshold).

Harvesting losses. Selling securities or other capital assets at a loss offsets capital gains, reducing net investment income.

Investing in municipal bonds. Net investment income doesn’t include tax-exempt interest from municipal bonds or municipal bond funds.

Buying corporate bonds at a discount or near par value. This minimizes the amount of interest earned on these bonds since coupons will be closer to market rates. Investing in tax-deferred annuities or permanent life insurance. Tax-deferred growth minimizes NII tax.

Investing in non-dividend-paying growth stocks. Because these stocks don’t generate any current income, they can help you reduce both your MAGI and your investment income. But they may increase both in later years when they’re sold.

Shifting income to family members. Consider giving assets that generate investment income to lower-income family members who aren’t subject to the NII tax. There are many ways to accomplish this, including outright gifts and gifts to trusts or family limited partnerships.

Setting up a charitable remainder trust. If you need the income from appreciated assets but want to avoid the capital gain and net investment income taxes a sale would generate, consider contributing the assets to a charitable remainder trust. As a tax-exempt entity, the trust can sell the assets and reinvest the proceeds in income-producing property without paying NII taxes. You receive a regular income stream (some of which may be subject to NII taxes) with the remainder distributed to charity at the end of the trust term.

Look at the big picture

As you explore strategies for minimizing NII taxes, don’t lose sight of the big picture. For one thing, investment and estate planning decisions should never be driven by taxes alone. In addition, many of the strategies that reduce MAGI or net investment income today may increase them down the road, so it’s important to consider these strategies in the context of your overall financial plan.

Investment advisory services offered through Rehmann Financial, a Registered Investment Advisor not affiliated with Royal Alliance Associates.

Published in Tax

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