Maximizing workplace retirement plans to reduce or eliminate the net investment income tax

Abram Claude, Vice President, Columbia Management Learning Center | November 6, 2014

  • The net investment income tax (NIIT) is a new, permanent tax that began in 2013.
  • Investors’ workplace retirement plans, such as 401(k) plans, may offer several opportunities to reduce exposure to the tax.
  • The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.

Many higher-income investors with taxable investments encountered a new tax that began 2013: the 3.8% tax on net investment income (NII). The NIIT applies to the lesser of the amount of: (a) Modified adjusted gross income (MAGI) that exceeds an income threshold based on tax filing status or (b) NII. (Related reading: What is the Net Investment Income Tax, and how is it calculated?)

However, investors may be surprised to learn there are ways to “rearrange” or reassign income in order to lower MAGI and/or reduce NII that counts towards the application of the tax. This rearranging can potentially reduce or eliminate altogether the impact of NIIT. Investors’ workplace retirement plans, such as 401(k) plans and nonqualified deferred compensation plans, may offer several opportunities to reduce MAGI and/or NII.

  • Maximizing salary deferrals to a 401(k) plan. Pre-tax salary deferrals reduce an investor’s MAGI up front and they are never counted as NII. Neither are the earnings they may generate while held in the 401(k). Remember, though, that any distributions of pre-tax dollars from a 401(k) plan increase an investor’s MAGI when eventually withdrawn.
  • Making 401(k) designated Roth contributions. Although Roth 401(k) contributions are included in MAGI up front, they are never counted as NII. Better yet, if they grow while held in the 401(k), any gain is tax-deferred and excluded from NII, and qualified distributions are tax-free — meaning they are not included in NII or MAGI when withdrawn.
  • Nonqualified deferred compensation plans. Contributions to nonqualified deferred compensation plans do not count toward MAGI. Their earnings, if any, while held in the plan are tax-deferred and do not constitute NII. Distributions from nonqualified deferred compensation plans are not considered NII, but they would be considered in MAGI.
  • After-tax 401(k) contributions. Another often overlooked opportunity that could enable participants to shelter more money in a tax-deferred account, even if they have maxed out their salary deferrals, is a standard after-tax contribution account in their 401(k) plan. Over 56% of defined contribution plans, according to the Plan Sponsor Council of America, have so-called after-tax accounts, which are separate from designated Roth contribution accounts. Here’s how a standard after-tax contribution account can help. Let’s say Tina and Terry, a married couple, max out their pre-tax contributions in their workplace retirement plans in order to keep their combined income below a tax threshold. Let’s also assume Terry’s workplace retirement plan has an after-tax contribution account. It happens that the combination of Terry’s salary deferrals and the company’s match that he receives does not cause Terry to reach his overall plan contribution limit for the year (known in the industry as the “415 limit”). That means there is room for Terry to potentially contribute more to the plan through his after-tax contribution account.

Of course, tax considerations are only one aspect of an investor’s financial plan. Investors should only make investment decisions after consulting with their personal tax advisors who will help them take into consideration specific financial needs, objectives, goals, time horizons and risk tolerance.

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Next in our series:

  • Maximizing salary deferral options for employees with a personal business or income
  • Small business: Why the new tax regime merits another look at workplace retirement plan design

 

This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Management does not provide tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.