Year’s end may seem a long way off. But if you’re an investor, you’d be smart to start projecting your income for the rest of the year right now. Why? In a word, taxes — namely, the net investment income tax (NIIT).
CONFRONTING THE THRESHOLDS
The Affordable Care Act of 2010 created two additional taxes under Medicare to help offset the act’s costs. One was an additional 0.9 percent tax on wages and self-employment income that exceed specified thresholds. For the purposes of this article, let’s focus on the other: the NIIT, a 3.8 percent tax on net investment income to the extent a taxpayer’s modified adjusted gross income (MAGI) exceeds certain thresholds.
Those thresholds are $200,000 for single filers and taxpayers filing as heads of household, $250,000 for married taxpayers filing jointly and $125,000 for married taxpayers filing separately. For most people, MAGI is equal to AGI. One notable exception, though, is for certain U.S. citizens or residents who live abroad and have foreign earned income. Note that these thresholds may, in effect, impose a “marriage penalty” on certain couples by imposing the NIIT where it wouldn’t apply if they were unmarried individuals.
“Investment income” can mean a variety of things. It includes, in general, gross income from interest, dividends, annuities, rents and royalties. The term can also apply to net capital gains. Also qualifying is trade or business income that is derived from either a “passive activity” under IRS rules or trading in financial instruments or commodities.
Investment income doesn’t include distributions from IRAs, pensions, 401(k) plans or other qualified retirement plans — but distributions from these plans can trigger additional Medicare taxes on net investment income by increasing your MAGI.
MAKING THE RIGHT MOVES
Once your total investment income is determined, deductible investment expenses are subtracted to arrive at net investment income. There are, however, several potential strategies you can implement to reduce or eliminate the 3.8 percent tax on net investment income.
First, you might execute a Roth conversion. If you have substantial balances in a traditional IRA, 401(k) or other qualified retirement plan and you’re considering a Roth conversion, now may be the time to do it. While doing a conversion and increasing your 2016 income may mean that you’re subject to the NIIT this year, future distributions from the Roth IRA are excluded from MAGI, reducing your exposure to the 3.8 percent tax in those years.
Remember, too, that the conversion amount will be included in your gross income this year and subject to tax, but not the 10 percent early withdrawal penalty. Also keep in mind that you’ll have to wait the requisite five years after the conversion to distribute the converted funds or you’ll face a 10 percent penalty.
If you have highly appreciated securities that you’d like to divest, consider the NIIT implications. Perhaps selling all at once this year is advisable because, even with the sale, you won’t be subject to the NIIT. Then again, waiting until next year, or selling some this year and some next year, may better reduce or avoid the NIIT. Whatever you decide, be mindful of the investment risk associated with holding an asset.
Installment sales can also help mitigate the NIIT’s impact. For sales of appreciated assets, consider using the installment method to spread the gain over several years. Depending on your situation, this may allow you to keep your MAGI below the threshold and avoid the 3.8 percent tax or at least minimize your exposure.
Also look into harvesting losses. In years in which you recognize large capital gains, you might want to sell assets in which you have losses. You can use the losses to offset the gains, reducing your investment income and your MAGI.
MANAGING THE IMPACT
The good news is that because the threshold for the NIIT is based on MAGI, strategies that reduce your MAGI could also help you avoid or reduce NIIT liability. Making retirement plan contributions is one example.
This has been a general discussion and is not intended as advice. Tax matters can be complex so seek the advice of a qualified professional before making decisions.
Norman Grill is a certified public accountant and managing partner of Grill & Partners LLC, CPAs and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien. He can be reached at 203- 254-3880.