2016 Tax Planning for Investment Income

What Will Be Considered Investment Income?

Investment IncomeInvestment Income

  • Interest, Dividends, Capital Gains (long and short) including the gain on the sale of investment real estate and second homes)
  • Annuities (but not annuities in IRAs or company plans)
  • Royalty Income
  • Passive Rental Income and Other Passive Activity Income
  • Above items from a child’s tax return that are reported on a parent’s return (the “Kiddie Tax”)

NOT Investment Income

  • Wages and Self-Employment Income
  • Active Trade or Business Income (including interest, dividends capital gains)
  • Distributions from IRAs, Roth IRAs, and Company Plans
  • Including Net Unrealized Appreciation
  • Excluded Gain from the Sale of a Principal Residence
  • Municipal Bond Interest
  • Proceeds of Life Insurance Policies
  • Social Security and Veterans’ Benefits
  • Gains on the Sale of an Active Interest in a Partnership or S Corporation
  • Taxable income from items that are NOT investment income can push taxpayers over the income threshold and cause investment income to be subject to the 3.8% surtax.

MAGI (Modified Adjusted Gross Income) Thesholds for 3.8% Surtax

Married Filing Joint           $250,000
Individuals                        $200,000
Married Filing Separate    $125,000
Trusts and Estates           $12,400*

*Trusts are hit hard – The 3.8% surtax kicks in at much lower income levels for trusts. The threshold for trusts and estates is the amount at which the top trust tax bracket takes effect. This amount is $12,400 in 2016. All other threshold amounts are NOT indexed for inflation

MAGI (Modified Adjusted Gross Income)

  • The 3.8% surtax applies to net investment income when MAGI exceeds these threshold amounts.
  • For this purpose, MAGI is a taxpayer’s regular AGI, plus any foreign income excluded from AGI
  • The 3.8% Medicare tax is imposed on the lesser of (1) net investment income or (2) the amount of MAGI over the threshold amount

Other Health Care Tax Provisions

  • Additional 0.9% Medicare tax on wages and self-employment income over the threshold amounts
  • Medical expenses must exceed 10% of AGI to be deductible (if age 65 or older, effective in 2017) – the 10% also applies to the medical expense exception to the 10% penalty on early IRA or plan withdrawals

Tax Planning Points

1 – The 3.8% tax is in addition to the tax rates for high income individuals. Those at the top brackets can have long-term capital gains and dividends taxed at 23.8% and other investment income taxed at 43.4%

2 – IRA and plan distributions (including sales of employer securities with net unrealized appreciation) are exempt from the 3.8% surtax on net investment income, but taxable distributions from these accounts can push income over the threshold amounts causing other investment income to be subject to the tax

3 – Roth conversions will increase current income, but future tax-free Roth distributions will be more valuable as a means to eliminate taxable income and required minimum distributions from traditional IRAs

4 – The 3.8% surtax is subject to the estimated tax provisions

5 – Taxpayers who have named a discretionary (accumulation) trust as their IRA beneficiary should consider ROTH conversons to avoid potential harsh trust tax rates at low trust income levels – or consider a conduit trust

6 – Salary deferrals (401(k), 403(b), etc.) can reduce MAGI for the 3.8% surtax but cannot reduce earned income for the 0.9% additional Medicare tax

7 – Net investment income can be reduced by allocable deductions such as investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local taxes allocable to the investment income

Copyright 2016, Ed Slott and Company, LLC