Minimizing “Net Investment Income”

The Affordable Care Act established a new 3.8% surtax on “net investment income” that first applies in 2013. This tax only applies to you if both of the following are true:

  • Your modified adjusted gross income (MAGI) is more than $200,000 (single or head-of-household) filers) / $250,000 (joint filers) / $125,000 (married-filing-separately filers), and
  • You have net investment income such as income from dividends, interest, and capital gains on investments, or net rental income (for non-real estate professionals who meet certain criteria).

The tax is only assessed on the net investment income that exceeds those thresholds – so if a married filer has $30,000 of net investment income and $255,000 in gross income, the additional 3.8% tax is only imposed on the $5,000 by which gross income exceeds the $250,000 threshold for married-filing-jointly taxpayers.

The tax is not assessed on income from wages, active business income, retirement plan distributions, or any source that isn’t taxed for regular income tax purposes, such as muni bond interest and excludible gain from the sale of your home.

Assuming this tax applies to you, what can you do to manage it?

Here are a few ideas to consider – although we certainly recommend that you discuss this with us and your investment advisor before acting, as not all suggestions will be right for everyone.

  • You could shift your portfolio away from investments that produce taxable earnings (such as dividend paying stocks) and towards investments that pay nontaxable earnings (such as municipal bonds). This would only make sense if the 3.8% surtax decreases your after-tax investment yield sufficiently to make lower-paying nontaxable investments such as municipal bonds sufficiently attractive for you.
  • Shift investments from income-producing  investments to growth stocks or mutual funds. You would still recognize capital gains (which are subject to the surcharge) when investments were sold, but you would be in control of the timing. You might be able to bunch sales into lower-income years.
  • If you are concerned about the surtax during retirement, consider Roth IRA conversions to provide a pool of nontaxable cash flow in retirement. This could permit you to keep your gross income below the threshold at which the surtax is imposed when you begin taking distributions from retirement accounts. Since a Roth conversion is not considered net investment income, the conversion itself would not be subject to the 3.8% surtax (although it would be taxable).
  • If one component of your net investment income is passive earnings from a flow-through entity, consider whether it’s possible for you to become more active in the business. If you work for the business for 500 hours or more during the year, your earnings would not be subject to this surtax.
  • If one component of your net investment income is net earnings from rental properties, talk to your tax advisor to determine whether you are on the edge of being considered a real estate professional. It’s possible that minor changes in your activities could make the difference in whether your rental income is considered net investment income. See this discussion from our real estate niche to learn more.

A final thought – this 3.8% surcharge is no more or less than it seems. It’s an additional 3.8% tax imposed on certain earnings. Since even with this 3.8% tax your earnings are not taxed at a 100% rate, it’s still better to make money than not to! As always, planning is the best way to manage your tax liabilities. Contact us if you would like us to prepare a tax projection to anticipate the surtax’s impact on you.

Author: Susan Sterne, CPA, Principal

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