- Higher earners with taxable investments are most susceptible to triggering the net investment income tax, a surtax of 3.8% that applies to taxable investments.
- An asset location strategy involves placing a greater percentage of the most tax-sensitive investments in tax-deferred accounts.
- Retirement plans offer significant opportunities for participants and business owners to reduce taxable income.
In 2013, new taxes associated with the Affordable Care Act of 2010 and the American Taxpayer Relief Act of 2012 took effect. Unlike the major tax legislation enacted over the last 12 years, the core tax provisions were passed by Congress absent of any expiration dates. This means that investors with taxable accounts who do not develop a tax plan could experience lower after-tax returns for the foreseeable future. The tax tail should not wag the investment dog. But there are steps that investors can take to improve after-tax returns by mitigating the additional tax bite that began in 2013.
Managing the differential in tax treatment of securities through asset location
Investors with sizeable investments in taxable accounts, especially investors who are still working and are not currently living on their investments, should consider a strategy for sheltering tax-sensitive securities through asset location. Once an optimal asset allocation strategy is in place, the overlay of an asset location approach involves placing a greater percentage of the most tax-sensitive investments in tax-deferred accounts.
For instance, investors pay tax on the interest from taxable fixed-income securities such as corporate bonds at their marginal income tax rate. For high earners, this could be 33% or 35%. On the other hand, many investors pay tax on income from qualified stock dividends at a far lower 15% long-term capital gains tax rate. Even investors in the highest income tax bracket of 39.6% face a lower long-term capital gains rate of 20%.
Given the significant differential in tax treatment, it could make sense to place more taxable fixed-income securities in a tax-deferred account, not only to defer taxation now but also because the taxable portion of eventual distributions will also be taxed as ordinary income. The second reason to consider asset location is the net investment income tax.
What is net investment income tax, and how does it work?
Higher earners with taxable investments are most susceptible to triggering the net investment income tax (NIIT). Here are some key points you should know:
- The net investment income tax is a surtax of 3.8% that applies to taxable investments.
- Taxpayers who cross a modified adjusted gross income (MAGI)* threshold of $200K (filing single) or $250K (filing joint) will trigger a net investment income tax calculation where they will need to compare the amount by which they cross the threshold to the amount of net investment income (NII).
- The surtax applies to the lesser of the amount over the threshold or the net investment income amount.
- Although wages and distributions from IRAs and qualified plans (among other things) are NOT counted as net investment income, they can expose a greater amount of net investment income to the 3.8% surtax by pushing more or all of NII above the threshold.
- This surtax is in addition to any other tax obligation incurred, whether it is derived by the standard tax calculation or the alternative minimum tax (AMT) calculation.
Managing the 3.8% surtax on taxable investments
How does asset location address net investment income tax? Investments in tax-deferred accounts are not subject to any taxation while held in the account, including the NIIT. And distributions of taxable income from tax-deferred IRAs, defined contribution plans and non-qualified deferred compensation plans are not included in net investment income. The taxable portion of distributions will push up your MAGI, but will not count as NII. Since the surtax applies to the lesser amount, this could be a tax-savings factor during the distribution years. NOTE: One exception is the distribution of earnings from non-qualified annuities (annuities held in taxable accounts). In this case, distributed earnings are included under net investment income.
The role of tax exemption
For investors who apply an asset location approach, but are seeking income in taxable accounts, tax-exempt municipal securities should be given serious consideration. Taxable equivalent yields on interest from municipal securities are increasingly favorable compared to taxable fixed income, and this interest does not increase MAGI or NII. For this same reason, high earners should find tax-efficient ways to acquire Roth assets. Qualified distributions from Roth accounts do not increase MAGI or NII.
Deferral of earned income
Earned income (wages and self-employed income) increases MAGI, which in turn could expose a greater amount of NII to the 3.8% surtax. To avoid moving into higher income tax brackets and/or to mitigate the amount of ordinary income exposed to the higher income tax brackets of 33%, 35% and 39.6%, working investors should consider steps to defer earned income.
Maximizing pretax contributions to defined contribution plans is a start. For those eligible to participate in nonqualified deferred compensation plans, this could be the next step. This can be especially important for senior and executive employees who participate in stock compensation plans. The execution of non-qualified stock options or the vesting of restricted stock create supplemental wages, which increase MAGI and can push more income into higher tax brackets. This could be at least partially offset by contributing a portion of wages or bonus to a non-qualified deferred compensation plan, which lowers current wages, provides tax-deferred growth and, when distributed, will not be included as net investment income.
Plan design for business owners and professional groups
Small business owners, and partners in professional groups with strong cash-flow, often take sizeable pass-through distributions from their business in addition to salary. These distributions increase MAGI and increase potential exposure to higher ordinary income tax brackets and to the net investment income tax. Plan design could lower taxable income, lead to an immediate tax deduction for the business, shelter investment growth and reduce what will be included in NII.
One tax-deferral strategy gaining in popularity due to its ability to annually defer meaningful amounts of income is a cash balance defined benefit plan. A cash balance plan may be the best tax-deferral option for owners, key employees and professional partners if their corporate structure will not support a non-qualified deferred compensation (NQDC) plan. In addition, as a qualified plan, it provides both judgment and bankruptcy protection that an NQDC does not.
Investors and financial advisors can take proactive steps to maximize after-tax returns in a higher tax environment where “what you keep” is an important investment concern.
Learn more in our original series, "Navigating the New Tax Regime"
* In the case of the net investment income tax, Modified Adjusted Gross Income = Adjusted Gross Income + certain excluded adjusted foreign earned income.