One of the funding mechanisms for health care reform is a new 3.8% Medicare contribution tax on net investment income (NII) going into effect this year. The tax applies to higher-income individuals as well as to trusts and estates.
From an estate planning perspective, implementing strategies to reduce or eliminate the 3.8% tax is important for several reasons. First, these strategies help preserve more wealth for your heirs. Second, the tax will have a big effect on trusts, so you might want to consider techniques for reducing trust income. Finally, many popular estate planning tools — such as family limited partnerships (FLPs) and lifetime gifts — can also help mitigate the impact of the tax.
Does the tax affect you?
For individuals, the 3.8% tax applies to NII to the extent modified adjusted gross income (MAGI) exceeds the applicable threshold: $250,000 for joint filers, $200,000 for single filers and heads of households, and $125,000 for married filing separately.
MAGI is your adjusted gross income (AGI) plus, if applicable, your foreign earned income exclusion. Unless you live and work abroad, MAGI is the same as the AGI reported on your income tax return.
The 3.8% tax applies to the lesser of 1) your NII (gross investment income less deductible investment expenses) or 2) the amount by which your MAGI exceeds the applicable threshold. (For a list of income types subject to the tax, see the sidebar “What constitutes investment income?”)
For trusts and estates, the tax applies to undistributed NII to the extent AGI exceeds the highest tax-bracket threshold ($11,950 in 2013).
How can you soften the blow?
For individuals, there are two ways to minimize the impact of the 3.8% tax: 1) reduce your MAGI (to bring it below the applicable threshold or at least minimize your exposure to the tax), or 2) reduce your NII. Strategies to consider include:
Converting a traditional IRA to a Roth IRA. Distributions from a Roth IRA don’t count toward the MAGI threshold, nor are they considered NII. However, the converted amount will be included in your MAGI in the year of conversion.
While the converted amount won’t be included in NII and thus won’t be subject to the 3.8% tax, the MAGI increase could trigger the 3.8% tax on your NII or increase the amount of your NII that’s subject to the tax. A series of partial conversions may allow you to enjoy the Roth IRA distribution benefits while avoiding or minimizing the 3.8% tax in the years of conversion.
Maxing out contributions to traditional IRAs and employer-sponsored retirement plans, such as 401(k)s. These contributions reduce MAGI, and distributions aren’t included in NII (although distributions are included in MAGI and thus could trigger or increase the 3.8% tax on your NII).
Shifting some of your portfolio into tax-exempt municipal bonds. Tax-exempt interest is excluded from both MAGI and NII.
Deferring income (through your employer’s nonqualified deferred compensation plan, for example). This will reduce your MAGI.
Making gifts of NII-producing property to lower-income family members or to charity. This will reduce your MAGI and NII, and the recipients will pay lower or no tax on the income.
Setting up an FLP to hold investment assets and gifting interests to your children or other family members. This strategy can lower your NII by shifting investment income to individuals with income below the MAGI threshold. It also can produce gift and estate tax benefits.
Instituting installment sales of business or investment property. By spreading capital gains over several years, you can reduce MAGI and, in the case of investment assets, reduce NII.
For trusts, reducing AGI generally isn’t an option. But there are several strategies for reducing NII, such as shifting assets into tax-exempt or tax-deferred investments or distributing income to lower-income beneficiaries. (The 3.8% tax applies only to undistributed NII in a trust.)
Another strategy for avoiding the tax on trust income is to use a grantor trust, whose income is passed through to you, as grantor. Keep in mind, though, that this strategy may increase your exposure to the tax.
The big picture
Tax planning is important, but it’s not the only factor. As you weigh your options for reducing the 3.8% tax, be sure to consider how they fit into your overall estate and financial plans.
Sidebar: What constitutes investment income?
For purposes of the 3.8% Medicare contribution tax, net investment income (NII) includes:
Interest, dividends, annuities, rents and royalties (unless derived in the ordinary course of an active trade or business),
Income from investments in partnerships or other businesses in which you don’t actively participate,
Income from trading in financial instruments or commodities, and
Net capital gains from the disposition of property (other than property held in an active trade or business) to the extent included in taxable income.
NII doesn’t include:
Income from an active trade or business,
Distributions from IRAs or qualified retirement plans, as well as payouts from qualified employer-sponsored pension plans or annuities,
Interest on tax-exempt municipal bonds,
Life insurance proceeds, Social Security benefits and veterans’ benefits,
Gain on the sale of an active interest in a partnership or S corporation, and
Gain on the sale of a principal residence that’s excluded from income under Internal Revenue Code Section 121 (up to $250,000; $500,000 for joint filers).