Helping our Clients with Investment Portfolios Navigate the 3.8% Net Investment Income Tax

By Baker Newman Noyes December 3, 2013

The month of December marks a critical time on the calendar of tax advisors looking to help clients with final year-end planning recommendations. Each year, new variables present themselves as hurdles to our clients’ ability to understand and implement these recommendations. Currently, clients are increasingly asking us what impact the new 3.8% net investment income tax will have on their tax liability, and for possible solutions.

Background on the tax

The net investment income tax first took effect January 1, 2013. It is equal to the lesser of two amounts: 1) net investment income or 2) the excess of modified adjusted gross income (MAGI) over a threshold amount. This concept of a threshold is a critical component in the mechanics of the tax. The amounts for individual taxpayers are:

1. $250,000 – taxpayers filing joint returns or surviving spouses
2. $125,000 – married taxpayers filing separate returns
3. $200,000 – taxpayers filing single or head of household

As it relates to net investment income, there are three categories of income to consider. The two categories at the forefront of planning considerations for clients with significant investment portfolios are:

1. Gross income from interest, dividends, annuities, royalties, and rents. These are “unearned” amounts, not derived in the ordinary course of a trade or business.
2. Net gain from the disposition of property not held in a trade or business.

A third category of income, the gross amount derived from a trade or business that is passive in nature, may also impact some clients.

What is on the minds of our clients?

The tax is confusing, especially in this initial year. Particularly confusing to clients is how all the mechanics relate to each other, especially in relation to MAGI. Beyond the 3.8% tax, clients are also reading about 1) a higher marginal tax bracket of 39.6% for ordinary income and short-term capital gains over $450,000 ($400,000 for single filers), and 2) a new rate of 20% for long-term gains for filers who exceed those same thresholds.

For the client subject to any, or all, of these increases, the math appears impossible. These clients turn to us to help quantify, via pro forma projection, the estimated liability, and whether it necessitates increased withholding or estimated payments by year-end.

How can advisors collaborate and add value?

It is not possible to provide a perfect solution to every client. But an effective solution can take several forms, such as:

1. Motivating the broader conversation of the 3.8% tax in your year-end performance reviews, specifically as it relates to estimated taxes. For clients where little can be done to change the outcome, explain to them that a solution might be available to manage tax withholdings, and thereby smooth out the impact. Many clients are accustomed to having their quarterly estimated tax amounts based upon prior-year safe harbor amounts. For the client whose exposure to the 3.8% tax will fluctuate each year, it might make sense to instead base estimates on current year projections.
2. Not overlooking the impact of MAGI, and the related threshold, on this equation. For clients who have significant net investment income, it might be possible to work proactively to limit other income items, or increase deductions. This might keep them under the threshold entirely.
3. For clients who are non-resident aliens married to citizens, explaining to them that they might consider different options for filing status. The citizen spouse who files married and separate would be subject to the threshold of $125,000, while the non-resident spouse would not be subject to the tax. If a decision is made to file married and joint, the threshold would be $250,000.

In relation to the second point, we advise clients on a variety of strategies for immediate consideration, where applicable. Such items include:

1. An increased focus on capital loss harvesting to offset same-year capital gains.
2. Distributions from Roth IRAs, as opposed to traditional IRAs, to limit taxable income. This might mean considering the ultimate benefits of converting a traditional IRA to Roth status, or the current year benefits of the distribution itself.
3. Qualified charitable distributions directly from IRA accounts for eligible taxpayers. These amounts, although not allowable as itemized deductions, are also not includible in taxable income.
4. Utilization of charitable remainder trusts, particularly to receive appreciated stock positions. Although income payouts to the beneficiary are taxable income, the trust itself is exempt from income tax. Gains realized are not subject to the 3.8% tax at the trust level.

There may be other strategies to consider, particularly in relation to future tax years. For example, the inclusion of municipal bonds in a fixed income portfolio may be advisable if it meets with the client’s overall investment goals.

If you think one of these strategies might be helpful to one of your clients, and you are interested in further quantifying the impact, please don’t hesitate to contact Jean McDevitt at 1-800-244-7444.