When we first told you about the 3.8% Net Investment Income (NII) tax back in 2010, we noted areas of uncertainty. Recently, the Treasury Department and the IRS released proposed regulations that help clarify many issues. Before discussing the proposed regulations, recall that the NII tax is part of the Health Care and Education Reconciliation Act of 2010 (Obamacare) and applies to those taxed in high brackets.
Specifically, the tax is 3.8% of the lesser of:
- Net investment income, or
- The excess of
- Modified adjusted gross income (AGI), over
- The threshold amount.
- For individuals, the threshold amount is $250,000 for those married filing jointly; $200,000 for single filers.
- For trusts and estates, the threshold is the dollar amount at which the top marginal income tax bracket begins (just under $12,000 in 2013).
What constitutes “net investment income”? It is gross income from:
interest, dividends, annuities, royalties, rents, and net gain from the sale of property, reduced by deductions related to this income; these items of income derived from a passive activity are also net investment income.
Net investment income does NOT include a distribution from a qualified plan or IRA and does NOT include any amount subject to self-employment tax.
The proposed regulations help to clarify many aspects of the original legislation. However, it is important to note that the proposed regulations themselves are silent on some key issues and the “clarity” is found only in the preamble. While the preamble is helpful guidance, it is not legal precedent. The proposed regulations could also change significantly before they are finalized.
Here is a summary of the more relevant parts.
1. Nonqualified annuities
Income from annuities is net investment income under the Code, but what exactly does the Code mean when it says “annuities”? The proposed regulations are silent, but the preamble to the proposed regulations offers some clarity. According to the preamble, net investment income includes any amount included in gross income that is received:
a. during the annuitization phase (i.e., “as an annuity”) from an annuity, endowment, or life insurance contract, taxable under §72(a) and §72(b);
b. from an annuity contract during the deferral phase (i.e., not received “as an annuity”), taxable under §72(e);
c. from the sale of an annuity.
Keep in mind, however, that these are all events which already trigger tax. At these times, the taxable portion of the distribution is also net investment income for the purposes of the 3.8% tax. But so long as an annuity remains in deferral, it is not subject to the NII tax.
2. Life Insurance
Income from life insurance is not on the list of net investment income items under the Code. But as mentioned above, the preamble of the proposed regulations includes amounts received “as an annuity” under a life insurance contract in the definition of net investment income.
Even the preamble, however, does not list non-annuitized withdrawals from a life insurance contract or sales of a life insurance contract as net investment income. Thus, partial or total surrenders or sales might very will trigger taxable income—e.g., to the extent the withdrawn amount exceeds the investment in the contract-but—they are most likely not subject to the 3.8% tax.
3. Grantor Trusts
Not surprisingly, the proposed regulations provide that grantor trusts are not subject to the net investment income tax; instead, the individual grantor shall be treated as the recipient of the trust’s income for purpose of this tax.
Because two things are needed to trigger the tax—MAGI above the threshold and net investment income—those with a MAGI below the threshold amount need not worry about the NII tax. For those well above the threshold, the only way to reduce the tax is to reduce net investment income.
But for those with MAGI near the threshold amount, consider ideas that will both reduce net investment income and MAGI to an amount below the threshold. All of the following can reduce MAGI:
- Deferring compensation
- Triggering capital losses
- Contributing to a tax deductible retirement plan or IRA
- Establishing an employer-sponsored long-term care plan
- Avoiding dividend-paying stocks
- Buying tax-free bonds
- Delaying receipt of social security.
Investment options to avoid 3.8% NII tax include:
- Own assets that grow tax-deferred, such as nonqualified annuities and life insurance. Because there is not income during deferral, there is no net investment income.
- Buy assets that produce income that is specifically excluded from the definition of net investment income. For example, “interest” is on the list of net investment income, but municipal bond interest is excluded from gross income, and therefore not subject to the NII tax. Similarly, as stated above, non-annuitized distributions from life insurance are not subject to the NII tax.
- Contribution to a retirement plan or IRA, for the same reasons mentioned above. The growth of these of these arrangements is not taxable income to begin with, so they will not generate net investments income (even though the growth comes from interest, dividends, and capital gains inside these arrangements). Also, taxable distributions from these accounts are specifically excluded from the definition of net investment income.
The new 3.8% Net Investment Income tax is only one reason that high income taxpayers will be paying more in 2013. Other reasons include a higher top rate (39.6%) and reintroduced limitations on deductions. If owning assets that did not trigger current tax was a good idea before, it is even a better idea now.