What is your NIIT?
United States judge and judicial philosopher, Billings Learned Hand expressed the tax principal that “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase ones’ taxes.” With fall knocking at the door, there is still time to make changes, or course corrections before the end of the year.
Have you considered how the new Medicare taxes are impacting you and what could be done to be more efficient in your tax/investment strategies? The Medicare payroll tax increased from 1.45% to 2.35% and a new 3.8% surtax on net Investment Income (NIIT) in January 2013. If you are single, and have modified adjusted gross income (MAGI) of over $200,000; are married with MAGI of over $250,000; or have a trust or estate with income over $12,150, you are handing over additional taxes that may be avoidable.
What type of income is subject to the Medicare surtax? Net investment income includes taxable interest, dividends, capital gains, rental income, and royalties. It also includes the taxable portion of income from non-qualified annuities, and income from business activities where the taxpayer is not considered an “active” participant. Income not subject to the tax includes interest income from municipal bonds as well as distributions from IRAs or 401Ks. However, the income you receive from your IRA or qualified plan may increase your MAGI and push other income into the taxable territory.
What planning strategies can help you avoid or mitigate the 3.8% surtax? Start with utilizing available options to reduce your taxable income. Maximize your retirement plan contributions, fund your Flexible Spending Accounts, contribute to a Health Savings Account or deferred compensation programs.
Be mindful of transactions that may increase your income above the thresholds. For example, if you are expecting a large bonus, or selling highly appreciated assets, weigh your planning options. Consider an installment sale to spread income out if you are selling a business. You might want to consider using tax-favored tools to defer income, such as non-qualified annuities or life insurance. A charitable remainder trust or donor advised fund allows you to contribute appreciated assets and receive tax benefits to lower MAGI. Look at your investments. Municipal bonds are generally more attractive since the tax equivalent yield for taxpayers in higher brackets increases. With a trust, the threshold of taxation is only $12,150, so muni bonds can provide a very competitive tax equivalent yield if income is not being distributed to beneficiaries.
You might want to consider a Roth strategy. Contributions and conversions can be used as a way to hedge against the direction of future tax rates since distributions from ROTH are income tax free. Be careful with your conversion though as it may push you into the higher income threshold. This could be offset if you have net operating losses from a business venture.
Review your asset location. There could be reasons to position different types of assets into different types of accounts. For example, you may want to allocate your highly appreciating assets within your ROTH accounts to avoid realized capital gains. You don’t have to take Required Minimum Distributions out of your ROTH at age 70 ½ like you do traditional IRA plans.
Yes, avoiding or abating the surtax is smart tax planning, but this should meld with your overall financial life plan. Andrew Carnegie admonished “Surplus wealth is a sacred trust which its possessor is bound to administer in his lifetime for the good of the community.” I find that for most people, they would like to tell their money where to go, instead of asking where it went. We can bring clarity to what your “big picture” looks like. However, it takes time and effort to sort through the pieces and put the puzzle together. Are you up for the challenge?