The Extra Tax for High Earners You Probably Don't Know About (and how to avoid it)

The Net Investment Income Tax (NIIT) is hitting more Americans than it once did but there are strategies to avoid it.

Many more high-earning Americans are being hit with an extra tax called Net Investment Income Tax (NIIT). This 3.8% additional tax applies to those with a Modified Adjusted Gross Income (MAGI) of $200k for single filers, $250k for married couples, and $14,450 for trusts and estates. The NIIT applies to your excess MAGI over those thresholds or your net investment income, whichever is lower. This tax was enacted years ago to fund the Affordable Care Act and those thresholds mentioned previously are not adjusted for inflation. Therefore. more Americans have been affected by the NIIT, pushing their after-tax returns lower.

The following constitutes Net Investment Income:

• Interest

• Dividends

• Capital Gains

• Rental Income

• Royalties

• Annuities

• Passive income

Wages, Salaries, self-employment income, business income, distributions from IRAs/qualified retirement plans, and tax-exempt income are not considered investment income.. There are some broad strategies to consider that reduce the NIIT, or eliminate it altogether.

Review your Retirement Contributions

Maximizing your retirement contributions might be the lowest hanging fruit in reducing the NIIT and your overall tax bill. If you have access to an employee-sponsored retirement plan such as a 401(k) or 403(b), you should consider maximizing your annual contributions to your plan. For Self-Employed taxpayers, consider making contributions to a Solo 401(k), SEP IRA, or SIMPLE IRA. You may also want to consider making traditional or Roth IRA contributions in addition to the contributions to your qualified retirement plan. By maximizing your retirement contributions, you not only defer your taxable income, but you can lower your MAGI below the threshold thereby avoiding the additional 3.8% NIIT.

Roth IRA Conversions

Since distributions from IRAs are exempt from the NIIT, Roth IRA conversions benefit high income taxpayers by lowering their MAGI, and potentially avoiding the NIIT altogether. In addition, these converted amounts can eventually be withdrawn tax-free, provided the taxpayer owned the account for more than five years and is 59 1/2 years of age. The individual gets to reap the benefits of tax-free appreciation on their investments which makes this strategy an excellent wealth-building tool. This strategy is generally recommended when your tax rate falls below the top 37%.

Tax Bracket Management

If you have some tax-favored attributes such as Net Operating Loss, Capital Loss, and Charitable deduction carryovers, as well as Investment Tax Credits, you might want to look at harvesting gains on your investments. By recognizing gains on your investments in a year where you have favorable tax attributes, you're effectively reducing the tax liability owed on such gains, therefore, dodging potential exposure to the NIIT on your investment income in future years. This is where proactive planning with your financial advisor or tax professional is very important.

Consider Gifts and Charitable Trusts

Making outright gifts to children in the form of low cost basis investments that have appreciated in value might be wise to avoid any capital gains from sale. Additionally, Charitable Remainder Trusts (CRT) can defer income, in the form of an annuity, which are paid to the trust's beneficiaries over a period of time to lower your MAGI. Alternatively, you can form a Charitable Lead Trust (CLT), which works in reverse compared to a CRT where the charity of your choosing gets a stream of income for a determined period of time, and your beneficiaries receive a remainder interest. Both trusts are effective in shifting your income so that you do not exceed the thresholds that trigger NIIT.

Additional Strategies to Consider

As mentioned previously, check your portfolio towards the end of the year to see if any capital losses can be harvested to offset any gains you may have incurred throughout the year. Talk to a financial advisor about allocating some of your portfolio to tax-exempt municipal bonds as the income spun off from these funds does not count toward investment income. Additionally, if you expect a large gain from the sale of an asset, you may want to consider an installment sale to spread the gain out over a period of time instead taking it all at once. Finally, open up an HSA, if you haven't already, and are eligible to do so with a high-deductible health plan. Contributions and subsequent distributions are exempt from NIIT in addition to all of the other benefits they provide as a savings tool.

Conclusion

With more than triple the amount of taxpayers subject to NIIT in the last 10 years, it's more important than ever to talk to your financial advisor or tax professional to devise a plan that gets around this tax. 3.8% might seem like a small amount, but it warrants consideration especially when making investment decisions. It becomes more significant the more investment income you receive so it's best to avoid any potential drag on your investment returns. Everyone's financial situation is unique and not all of the strategies may be right for you. For any questions, feel free to contact me and subscribe to my newsletter for up-to-date information related to tax and financial planning.

IMPORTANT DISCLOSURES AVL CPA Firm, LLC. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.