Investment Strategies for Investors Subject to the 3.8% Net Investment Income Tax

With the ever-changing tax world, it is growing increasingly difficult to know how every piece of legislation or industry update affects clients and impacts their financial future. As a leader in the financial services industry for the past 30 years, we get it. That’s why HD Vest Financial Services® is constantly seeking ways to share the latest knowledge we acquire with you. We’ve created the Taxes & Investments: Timely and Timeless Strategies Series to share timely information and provide our Advisors and their clients with practical information and ideas they can build on.

The 3.8% Net Investment Income Tax

On January 1, 2013, the 3.8% surtax on net investable income created in the Health Care and Education Reconciliation Act of 2010 took effect. This 3.8% tax affects Americans with incomes over $200,000 single or $250,000 joint – in addition to any alternative minimum tax payable.

Which investment incomes are subject to this tax?

Not all investment incomes are subject to the tax, but many are. They include:

• Gross income from interest, dividends, annuities, royalties and rents.
• Gross income from a passive activity, or a trade or business of trading in financial instruments or commodities.
• Net gain to the extent taken into account in computing taxable income. This is more commonly known as capital gains.

It is important for high income Americans to employ strategies to reduce net investable income or to reduce their income below the IRS thresholds.

How can net investable income be reduced?

Tax exempt securities: Municipal securities are not subject to the 3.8% surtax. By investing in tax exempt securities, investors reduce their exposure to the surtax.*

Tax efficient models: Tax efficient models will be more important for the high net worth individual going forward. These models reduce the amount of capital gain by investing in funds that are sensitive to taxes and have a lower turnover rate.

Strategic investment placement: It is important to review which investments are producing large amounts of investable income and what registration those investments are currently held in. Investments with large amounts of income may be repositioned to tax deferred accounts, i.e., retirement plans, annuities, etc. Investments with low amounts of investment income could be repositioned to non-qualified accounts. This would reduce the amount of investable income reported on a 1099 for 2014.

Annuity distributions by exclusion ratio: Annuity income that is received through annuitization is taxed based on an exclusion ratio. This means that a portion of the income is treated as a return of basis and is therefore not taxed. Taxpayers currently taking annuity distributions should analyze their exposure to the 3.8% net investment tax.

Life insurance: Investors may benefit from investing in life insurance vehicles. Tax exempt loans or distributions from life insurance avoid the 3.8% surtax. Taxes only apply on loans from life insurance if the policy is a modified endowment contract.

Increase participation to make income non-passive: Only passive income is subject to the 3.8% surtax. If an investor has the ability to increase their participation in the business activity, they may be able to avoid the tax.

Capital loss harvesting: It is especially important to begin to look at tax loss harvesting. This is the process of selling investments that have a loss to offset investments that have a capital gain. By implementing this strategy an investor may avoid the 3.8% tax on gains that have been offset by the harvesting of the loss.

Installment sales: Taxpayers are sometimes able to spread out capital gain on a sale of property or business interest if it is spread out over a number of years. This could reduce the 3.8% net investment tax exposure.

With so many forms of investable income now subject to a 3.8% net investment tax it is important that high income taxpayers consult with an HD Vest Advisor to create strategies that may reduce the exposure to this new tax burden. Applicable strategies should be built within a suitable plan that also takes into account the investor’s risk tolerance, time horizon, objective and other pertinent investor information. By partnering with an Advisor, investor’s may be able to reduce their exposure to the 3.8% net income tax, or possibly, avoid it all together.