The 3.8% surtax on unearned income of higher-income individuals, which went into effect just last year, is likely to play a prominent role in your year-end tax planning. After working through the mechanics of the new tax for the first time in 2013, The Tax Warriors® have come up with a handy list of planning ideas aimed at reducing exposure to the surtax on investment income.
Overview of the Net Investment Income Tax
For tax years beginning after December 31, 2012, certain unearned income of individuals, trusts, and estates is subject to an additional 3.8% surtax. The surtax, formally called the "unearned income Medicare contribution tax" by only the most long-winded of Congressional tax namers, is more commonly referred to as the "net investment income tax,” or “NIIT” for short. The tax imposed is 3.8% of the lesser of:
(1) net investment income; or
(2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). This threshold amount is not indexed for inflation.
The NIIT is also imposed on certain income of trust and estates, when income exceeds certain levels. However, the planning points in this article will focus only on individuals.
For the 3.8% surtax, net investment income (NII) includes income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the NIIT doesn't apply. Passive income and gains from the disposition of certain property not held in a trade or business are also included in NII. Certain deductions attributable to investment income may reduce NII.
As with everything in the tax code, there are many exceptions to the rules above. Our previous article for the Philadelphia Estate Planning Council, Understanding and Planning for the New Net Investment Income Tax, covers many of the nuances contained in the Treasury’s grueling 100+ pages of regulations.
Since the 3.8% tax is only imposed on individuals with MAGI over $200,000 for single taxpayers and $250,000 for married tax payers, keeping MAGI below these levels will prevent the NIIT from kicking in. Often, MAGI is the same as adjusted gross income (AGI), which is computed before considering deductions. Therefore, managing income from year to year can be very useful in reducing or eliminating NIIT.
Some common ways to reduce MAGI include entering into installment sale agreements to defer gains. This can spread income over many years, as opposed to recognizing a significant income increase in the year of sale. Assume a single individual annually earns $100,000 of noninvestment income (wages, etc.) and also sold an asset subject to the NIIT for a $300,000 capital gain during the year (undeveloped land, rental property, etc.). If the entire gain is recognized as income in the year of sale, $200,000 will be subject to the NIIT ($400,000 total MAGI less the $200,000 threshold), resulting in $7,600 of additional tax. If the gain can be spread evenly over three years via an installment agreement and only $100,000 of gain is recognized in each year, the individual’s MAGI will remain below the threshold level and none of the gain will be subject to the NIIT. If you plan on closing a sale before year-end, consider deferring a portion of the payment until early next year so you can take advantage of the installment method, defer a portion of your gain, and possibly stay under the applicable NIIT MAGI levels.
The NIIT has made Roth IRA’s more advantageous, since their distributions will not increase an individual’s MAGI, while distributions from a regular IRA will. Note that distributions from either plan do not constitute net investment income, however, by increasing MAGI, regular IRA distributions can subject additional investment income to the 3.8% tax. Don’t worry if you’re phased out from making Roth IRA contributions, The Tax Warriors® can help you convert regular and nondeductible IRA contributions into a Roth. This can be good for both NIIT planning and overall tax planning.
But remember that this move, and other taxable IRA rollovers, can increase MAGI and potentially expose more of your NII to the 3.8% surtax. Therefore, such taxable rollovers are often best in years where income is low or there is a net operating loss to absorb some of the income.
To reduce NIIT, consider rebalancing your investment portfolio to emphasize growth stocks over dividend-paying stocks. While the capital gain from these investments will be included in NII, the surtax will be deferred until the stock is sold and capital gains can be offset by capital losses, which isn't the case with dividends. Harvesting capital losses at the end of the year is one way to reduce investment income, but be wary of the wash-sale rules that disallow such losses if the same security is purchased back within 30 days. Also consider the NIIT when exercising stock options or selling large positions in appreciated securities, as these moves will often trigger additional investment income. We strongly recommend you consult your financial advisor before adjusting your portfolio.
Many other strategies are available for reducing the NIIT, especially for business owners and real estate professionals. In all cases, care must be taken not to let “the tax tail wag the dog,” especially with a 3.8% tax. The Tax Warriors® at Drucker & Scaccetti can evaluate your situation and help you take a holistic approach to tax planning so only those ideas that make sense for you overall are implemented. Contact us at 215-665-3960 or via the “Ask A Tax Warrior” button below. Our specialized tax professionals are happy to offer advice.