Now that you have a basic idea of how the surtax works, we can turn to planning strategies to lessen the burden of the new tax. There are two main approaches to minimize the impact of the surtax. The first is to reduce your net investment income and the second is to reduce your MAGI.
There are a variety of tactics you could adopt to accomplish the first goal. Here are some ideas, a few of which we will cover in more depth:
- Municipal bonds
- Tax-deferred annuities
- Life insurance with cash value
- Rental real estate
- Oil and gas investments
- Choice of accounting year for an estate or trust
- Timing of estate or trust distributions
In determining if a municipal bond is preferable to a corporate bond, one must calculate the after-tax rate of return. Income from a corporate bond would be subject to both income tax and the net investment income surtax for a taxpayer whose MAGI exceeds the NIIT’s threshold. A municipal bond would not be subject to income tax, nor would it be subject to the new surtax, regardless of the taxpayer’s MAGI. Additionally, income from a municipal bond would not be included in MAGI either, so the municipal bond will help an investor stay below the threshold amount. Generally speaking, as tax rates go up (or new taxes are imposed), the after-tax yield of taxable bonds goes down, thus making municipal bonds more attractive.
Life Insurance with Cash Value
Whole and universal life insurance policies often include an investment component in addition to the death benefit. This is generally referred to as the policy’s cash value. All gains inside the life insurance policy are tax-deferred, and thus are not included in your MAGI and NII calculations.
Consider this example: Joe, a married-filing-jointly taxpayer, paid a one-time, $250,000 premium to purchase a $2.5 million universal life insurance policy. Ten years later, Joe withdrew $40,000 from the policy, when its cash value was $400,000 ($150,000 more than Joe paid originally). Until Joe withdraws more than his initial premium, none of the policy’s earnings will be subject to the NIIT.
Obviously, a given policy’s fees and investment options will affect its attractiveness as an investment, but its tax-deferred nature makes it more desirable in a higher tax-rate environment.
Tax Shelter Investments
In general, certain investments offering non-cash deductions (such as in oil and gas investments and rental real estate) are helpful as tax shelters, and their importance will increase for those looking to minimize or eliminate their surtax obligations. Oil and gas investments often provide intangible drilling costs deductions and rental real estate has depreciation deductions, both of which reduce your NII. It is important to stress however, that one should not allow the increased tax rates to completely control the investment process. Tax efficiency should be just one of many factors you examine when selecting an investment and evaluating its merits within the context of your overall financial plan and asset allocation.
Planning for Trusts and Estates
The NIIT can hit trusts and estates particularly hard because of the low threshold amount ($11,950 in 2013). In order to reduce the tax, fiduciaries may want to consider making distributions of the trust or estate’s net investment income. Because trusts and estates receive an income distribution deduction, the income is ultimately reported by the beneficiary, and any resulting NIIT will be based on the beneficiary’s personal income tax return. Assuming that a trust or estate has beneficiaries who are not subject to the NIIT, the choice to make distributions from the trust or estate can help to minimize the overall tax burden. This strategy may not be practical, however, if the trustee or grantor did not intend for the beneficiaries to receive distributions.
One other possible solution is to create multiple trusts, or to divide a current trust into multiple trusts. Each new trust will have its own threshold amount, essentially spreading the investment income from one big trust to numerous smaller trusts. As long as the undistributed NII of each trust is below the threshold, this strategy could allow a trust to avoid the NIIT completely. Note you have to have a legitimate reason for dividing a trust, such as maintaining separate trusts for multiple beneficiaries with different investment goals or setting up trusts for different primary objectives (such as education or health). Tax avoidance is not a legitimate purpose on its own. You must also consider the additional costs associated with maintaining multiple trusts, including tax preparation fees, annual accounting fees and trustee fees, when deciding whether this strategy makes sense in your situation.
Besides reducing net investment income, the other main approach for tax planning related to the new surtax is to take steps to reduce your MAGI to less than your applicable threshold amount. There are also a variety of strategies that can help you achieve this goal, including the following:
- Roth IRA Conversion
- Charitable Remainder Trust
- Charitable Lead Trust
- Installment Sales
Roth IRA Conversion
Depending on your time horizon and your overall tax situation, you may want to consider a Roth IRA conversion. Converting a traditional IRA to a Roth IRA should lower your overall taxable income in the long term. In addition, Roth IRAs do not have required minimum distributions and withdrawals for beneficiaries are tax-free. If the conversion would push your income above the threshold, consider converting over the span of several years instead. To employ this strategy effectively, it is ideal to use funds from outside the IRA to cover the income tax liability created in the year, or years, of conversion.
If you have philanthropic intentions, you might also consider a Charitable Remainder Trust (CRT) or a Charitable Lead Trust (CLT). Other articles can provide you an overview with how each trust is structured. The trust would reduce your MAGI while, at the same time, allowing you to meet your charitable objectives.
Another strategy to reduce MAGI is to structure certain dispositions of property as installment sales. An installment sale is one in which the seller exchanges an asset for a promissory note, paid over a period of time; thus the taxable gain that the seller recognizes will be partly deferred. By spreading the income over a longer period, the seller can prevent a spike in income after selling a highly appreciated asset, which would otherwise push their MAGI over the threshold in the year the sale takes place.
Depending on your goals, you can also reduce MAGI through an outright gift. Giving assets that produce significant investment income to recipients with lower MAGI can keep you, and ideally the gift recipient, below the surtax threshold. However, there are a few caveats to keep in mind when deciding whether to give for this reason. First, one must be comfortable relinquishing control over the asset. Second, under the so-called “kiddie tax” rules, the unearned income of young children may subject their income to their parents’ tax rate, including the new surtax. A gift needs to be planned carefully if one of the intentions is reducing the burden of the NIIT.
Even with these strategies for reducing MAGI and net investment income, you may still find yourself subject to the surtax. If this is the case, it is important to note that the surtax is subject to the estimated tax provisions. Therefore, you should promptly confirm whether the surtax applies and, if so, you should pay your estimated tax or adjust your withholdings as soon as possible to avoid underpayment penalties. Because net investment income can vary greatly from year to year, many taxpayers may prefer to rely on the safe-harbor rules for estimated payments. These rules require that you pay 100 percent (or 110 percent, for high-income taxpayers) of your prior year’s tax liability.
At this time, the IRS is still considering some of the issues related to the NIIT, but the Service has stated that taxpayers can rely on the proposed regulations until final regulations are issued. For now, it makes sense to plan for the new tax based on the proposed regulations.
While this new Medicare surtax may seem complicated, the overall planning strategies are relatively simple: reduce net investment income, reduce MAGI, or both. The best way to go about these measures will depend on your individual situation, but planning ahead will allow you a happier start to 2014, especially when your tax bill comes due in April.