Higher income taxpayers beware.  There is a new surtax to contend with.  Originating as a component of 2010 health care legislation and first effective in 2013, the 3.8% net investment income tax (3.8% NIIT) is assessed on the lesser of net investment income (NII) or modified adjusted gross income (MAGI) above specific thresholds.  The MAGI Thresholds are $200,000 for single individuals, $250,000 for joint filers and surviving spouses, and $125,000 for married taxpayers filing separate returns.

Only individual taxpayers with some amount of NII and MAGI above the applicable threshold amount will be subject to the 3.8% NIIT.  In other words, taxpayers with only wage or self-employment income are exempt.  For example, if a married couple has $500,000 of wage income and $100,000 of interest and dividend income (i.e., MAGI totaling $600,000), the 3.8% NIIT only applies to the investment income ($100,000), not the $350,000 that is over the $250,000 MAGI threshold.

Since the 3.8% NIIT is assessed on the lesser of NII or MAGI above the threshold, planning strategies to reduce the surtax will only be effective if they target the applicable exposure point.  IF NII is the lower number, planning strategies should focus on reducing investment income.  If the taxpayer’s MAGI is lower, reduction strategies should focus on reducing AGI.  The following strategies can be used to reduce NII and AGI.

NII can be reduced currently by:

  • Selling securities at a loss in a taxable account (also reduces AGI)
  • Using an installment sale to spread a large gain over several years (also reduces AGI).
  • Facilitating a like-kind exchange to defer gain (also reduces AGI)
  • Gifting appreciated securities instead of cash (also reduces AGI).

AGI can be reduced currently by:

  • Maximizing deductible contributions to a tax-favored retirement account, i.e. 401(k), SEP, and defined benefit pension plans.
  • For cash-basis self-employed individuals, deferring business income into the following year and accelerating business deductions into the current year.
  • Gifting appreciated securities to children and letting them sell the appreciated securities to avoid recognizing gains on the parent’s return (also reduces the parent’s NII).  Be aware that the Kiddie Tax may apply; however, the child will receive his or her own MAGI exemption from the 3.8% NIIT.

Longer-term strategies:

  • Convert traditional retirement account balances to Roth IRAs, but watch out for the AGI impact in the conversion year.  In the long run, gains and earnings that build up tax-free in a Roth IRA are not included in either AGI or NII when eventually distributed.
  • Invest in tax-exempt versus taxable bonds, which will reduce both AGI and NII.
  • Use tax-favored retirement accounts to invest in securities that are expected to generate otherwise-taxable gains and dividends.
  • Invest in life insurance and tax-deferred annuity products.  Life insurance death benefits are generally exempt from ordinary income tax and, thus, from the 3.8% NIIT, as well.  Death benefits will not increase the recipient’s exposure to the 3.8% NIIT by increasing his or her AGI.
  • Invest in rental real estate and oil and gas properties.  Depreciation, intangible drilling costs, and depletion deductions reduce both AGI and NII.

These are some of the ways to reduce exposure to the 3.8% NIIT.  Please contact us if you have questions or need additional information to eliminate or minimize your exposure to this new surtax.