How to Minimize the 3.8% Tax on Investment Income

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By Brandon Cook, CPA | Partner, Tax Services Group and Larry Greenwalt, CPA | Chairman of the Board

Many taxpayers experienced the impact of the Obamacare tax on investment income (defined below) when filing their 2013 taxes. This additional tax applies if your Modified Adjusted Gross Income (MAGI) exceeds $250,000 if filing joint, and $200,000 if unmarried. The amount subject to the additional 3.8% tax is the lesser of:

  1. Your net investment income, or
  2. The amount by which your MAGI exceeds the applicable threshold above.

(Essentially, MAGI is defined as regular Adjusted Gross Income taken from the bottom of page 1 of your return, plus certain excluded foreign source income net of certain deductions and exclusions)

Net Investment Income includes the following:

  1. Taxable interest and dividend income
  2. Net capital gains (from all sources)
  3. Taxable nonqualified annuity distributions
  4. Rental income and royalties received as passive income
  5. Passive income from partnership interests, S corporations if you are not actively involved, and Master Limited Partnerships.

It’s important to understand what is NOT included in Net Investment Income:

  1. Tax-exempt interest
  2. Distributions from IRA’s, 401(k)’s, and other qualified employer retirement plans
  3. Income from active trade or business (Schedule C, K-1’s, etc.)
  4. Veteran and Social Security benefits.
  5. W-2 Wages

There is a Medicare surtax of 0.9% on compensation (including self-employment income) on compensation above $200,000 (individual filers) or $250,000 (married/joint filers).

So now that you understand the rules by which we must play, let’s look at some strategies which may be helpful in lessening this additional tax burden, assuming your income is over the thresholds above:

  1. Reduce MAGI by maximizing your retirement plan contributions
  2. If possible, increase your involvement in your passive activities so that you qualify as non-passive
  3. Use College Choice 529 accounts to accumulate college funds for children and grandchildren rather than doing so in taxable accounts.
  4. You’ve heard the phrase “Don’t let the tax tail wag the dog”, and we agree with that especially as it relates to the following–these are ideas you could explore with your investment advisor:
    1. Invest in more tax-exempt funds versus taxable funds (but consider risks).
    2. Invest in growth stocks that have lower dividend payouts but may grow in value at a higher rate.
    3. Invest in tax deferred annuities.
    4. Manage your capital gains by spreading gains into two or more years where possible.
    5. Gift appreciated stocks, which you want to sell, to your children over the age of 23, which are in a lower tax bracket.
    6. Gift appreciated stocks to qualified charities instead of selling and making cash donations.
    7. Take unrealized capital losses to offset capital gains.
    8. Reduce the impact of one big transaction resulting from an unusual nonrecurring type of sale, such as the sale of a second home or investment property, etc. by:
      1. Selling on an installment basis and collecting the proceeds over 2 or more years.
      2. Consider a Sec 1031 tax free exchange, if that makes good business sense.

Now is the time to begin implementing the tactics that would be beneficial to you. Please give us a call if you have any questions or would like to discuss your tax planning needs further. Brandon may be reached at 317-260-4437 or bcook@greenwaltcpas.com and Larry may be reached at 317-240-4489 or lgreenwalt@greenwaltcpas.com.