As 2016 winds down, it’s time for many people to begin thinking about taxes. One tax you may want to focus on is the net investment income tax (NIIT). This tax adds 3.8% to individual income tax rates. Here are several year-end planning strategies to consider that can reduce or even eliminate the tax.
Are you subject to the tax?
The NIIT applies to high-income taxpayers, defined as those whose modified adjusted gross income (MAGI) exceeds these thresholds:
- Single: $200,000
- Married filing jointly: $250,000
- Married filing separately: $125,000
- Head of household: $200,000
For most people, their MAGI is the same as their adjusted gross income (AGI). But if you have foreign-earned income, it may be higher than your AGI.
Even if your income exceeds the threshold, the NIIT may not be a concern unless you have significant NII from taxable interest, dividends, capital gains, nonqualified annuities, rents, royalties, passive business activities, or businesses trading in financial instruments or commodities. NII does not include wages, self-employment income or income from businesses in which you materially participate. Also excluded are tax-exempt interest, distributions from IRAs and qualified plans, life insurance proceeds, nontaxable gain on the sale of a principal residence, alimony, unemployment compensation, and Social Security benefits.
If you’re subject to the NIIT, it applies to your NII or to the amount by which your MAGI exceeds the applicable threshold, whichever is less.
What are some strategies?
There are three general approaches to easing the impact of the NIIT:
- Reducing MAGI. This approach can reduce the amount of NII that’s subject to tax or, if your income level is close to the threshold, eliminate it altogether. Strategies include:
- Maximizing contributions to IRAs or qualified retirement plans,
- Deferring income to next year,
- Accelerating deductible expenses into this year,
- Postponing the sale of capital assets (also reduces NII), and
- Harvesting capital losses (by selling underperforming securities) to offset capital gains already recognized this year (also reduces NII).
Finally, if you’re selling a business interest or other investment property before the end of the year, consider an installment sale to avoid recognizing the entire capital gain this year. This will reduce NII.
- Reducing NII. Strategies to reduce your NII include harvesting losses, postponing capital gains and using installment sales, all of which also reduce MAGI.
If you plan to sell a significant capital asset this year, consider gifting it to a family member in a lower tax bracket who can sell it without triggering the NIIT. This also reduces MAGI.
Finally, review your participation in passive activities. It may be possible to raise your level of involvement in an activity to “material participation” by increasing the time you spend on it between now and the end of the year. Under those circumstances, the activity will no longer be passive and won’t be subject to the NIIT.
- Accelerating investment expenses. Remember, the tax applies to net investment income. You can reduce the NIIT (and MAGI) by accelerating deductible investment expenses into this year. For example, you might prepay property taxes on investment property, prepay state and local income taxes on investment income or prepay deductible investment interest expenses.
What about trusts?
For trusts, the NIIT kicks in at much lower income levels. In 2016, for example, the tax applies to trusts whose undistributed AGI exceeds $12,400. (See “Reducing your trust’s tax bill.”)
Be aware that the NIIT applies to only nongrantor trusts. Income earned by grantor trusts passes through to the grantor.
As you plan for future years, consider investment strategies that will minimize NIIT. Investments that allow you to avoid or defer NIIT include tax-exempt municipal bonds, tax-deferred annuities, permanent life insurance and nondividend-paying stocks.
As you evaluate tax-saving strategies, don’t lose sight of your overall financial picture. Reducing taxes is a legitimate goal, but not if it means sacrificing investment returns or hindering your retirement or estate planning goals. Turn to your tax advisor for guidance on which strategies may be appropriate for your situation.
Reducing your trust’s tax bill
Nongrantor trusts are subject to the net investment income tax (NIIT) to the extent their undistributed adjusted gross income (AGI) exceeds $12,400 (for 2016). Given the low-income threshold, it’s difficult to avoid the NIIT by reducing a trust’s AGI. But the trustee can reduce or eliminate NIIT by distributing the trust’s income to its beneficiaries (provided the trust document authorizes the trustee to do so).
Keep in mind that distributing the trust’s income may defeat the trust’s purpose if one of your objectives is to restrict or delay the beneficiaries’ access to the funds. If so, your estate planning goals may outweigh your interest in saving taxes.
If a trust holds passive business interests, you may be able to reduce or avoid the NIIT by increasing the trustee’s level of involvement. As with individual investors, trusts can avoid net investment income by materially participating in an activity.