Tax Strategies to Combat the Net Investment Income Tax

Upon implementation of the ACA comes new concerns with how your investment income will be taxed. Below I have outlined ways to reduce your modified adjusted gross income (MAGI) to offset the 3.8% net investment income tax (NIIT). The summary of these planning techniques is not intended to be "one shot fixes", but rather longer term planning direction and behavior change. You may need to consult with your investment advisor regarding your options, but among the tax concepts to consider are the following:

A.        Invest in tax-exempt bonds.

  • The  interest from such bonds does not get added into MAGI.
  • It is not considered Net Investment Income (NII).
  • If income tax rates increase, higher bracket taxpayers will find these bonds      attractive.

There is a concern that the current administration is going to suggest limiting the tax benefits of these bonds.  If that should occur, the strategy may have to be re-examined.  If that does come, the action is likely to be prospective only - on newly issued bonds, so that might suggest an urgency to acquire qualified tax-exempt bonds sooner rather than later.

Obviously, any investment in tax-exempt bonds should compare the yield on such bonds (possibly addressing AMT exposure to private activity bonds) with the net after tax return if both regular income tax, possibly AMT and Medicare tax were imposes on a taxable bond.

B.        Move investments from high-yielding dividend paying stocks to growth stocks that do not pay dividends, or that pay lower dividends.

C.        Capital loss harvesting.  Try to balance capital gains and losses in 2013 and later.  Of course, sensible investing should come first.  Keep in mind the wash sale rule is an issue when losses are realized.  Reacquiring the stock sold at a loss before 31 days have elapsed will result in the loss deduction being disallowed.

D.        Favor installment sales.  [IRC §453]  The idea here is to flatten out the "spikes" in gains, and spread the gains over more tax years, keeping both MAGI and NII at a lower annual level.

E.        Consider like-kind exchanges.  [IRC §1031]  With the drop in capital gain rates, like kind exchanges have slowed in recent years.  Bringing them back into favor suggests avoiding including gains in MAGI as well as NII.  Be careful that the timing rules of IRC §1031 (to identify an exchange property and to close the deal) are respected. There are specific steps that need to be followed with a like-kind exchange, beginning with consulting a qualified §1031 intermediary prior to any transactions.

F.         Invest in tax-deferred annuities.  In recent years when the taxpayer is working and earning a strong income and also earning a return on investment, the likelihood of being subject to the 3.8% Medicare tax is fairly high.  A strategy to consider here is to purchase a tax-deferred annuity that will delay payments for several years - perhaps until the taxpayer retires or at least until an age where the taxpayer expects less income to be earned.  At that time, MAGI may be lower, and the receipt of the deferred annuity payments will not push the MAGI above the threshold.

G.        Purchase a whole life (cash value) insurance policy. The current payment of premiums will remove dollars that might otherwise produce current NII.  The policy can build up.  Its growth is not taxable.  If desired in the future, withdrawal of policy earnings, even if adding to MAGI, can be timed to come in years when MAGI is otherwise low.  Coupled with the expectation of most tax advisers that income tax rates on wealthy will continue to rise, permanent life insurance inside an irrevocable life insurance trust is looking quite advantageous.  However, it does appear that life insurance surrenders and sales will be taxed along with the realization (i.e. cash out) of the inside build-up of the cash value in a policy in excess of the policy-holder's basis. [Rev. Rul. 2009-13.]

H.        Increase above-the-line deductions on Form 1040.  There are not a lot of "swing" deductions here.  The largest by far are for contributions to qualified retirement plans and to traditional IRAs.  Certainly when possible, maximize allowable contributions to these plans.

I.          Determine if business deductions are available. If the taxpayer is filing Schedule C as a sole proprietor, or has permitted deductible expenses on a Schedule E (S corporations, partnerships, etc.) these deductions and losses will also reduce MAGI.