How can we avoid the 3.8% Net Investment Income Tax?
● Try to keep our modified adjusted gross income below the statutory threshold so we are not subject to the 3.8% Net Investment Income Tax.
● Avoid increasing taxable income when we don’t have to, such as doing a Roth conversion. When we do a Roth conversion, all the earnings and tax-deductible portion of the Traditional IRA increase our income. I say the tax-deductible portion of the Traditional IRA because we don’t get tax on the amount we did not deduct. All earnings are taxable regardless if the earnings come from deductible and nondeductible contributions.
● It’s net investment income and not gross investment income. If we can increase investment expenses to lower our net income, that is another way to avoid the Net Investment Income Tax. Examples of expenses are rental property expenses, investment trade fees, and state and local taxes.
● Prepaid deductible investment expenses such as state and local income taxes on investment income, investment interest expenses, and property taxes on investment properties.
● Contribute to accounts that can reduce our income such as, 401(k) plan, 403(b) plan, 457(b) plan, SEP IRA, deductible Traditional IRA, TSP, health savings account, et cetera.
● Installment sales. If applicable, spread the gains from a sale of a business or investment property over multiple years instead of realizing all the gains in one year.
● If we are charitably inclined, we can donate appreciated assets to qualified charities instead of realizing the appreciated assets, pay the taxes, then donate the money. For clients that are age 70 1/2 or older and are charitably inclined, qualified charitable distributions (QCDs) are a great option.
● Sell investments at a loss to offset investment gains.
● Defer capital gain, such as selling the investment in the future instead of selling it now.
● Use Section 1031 like-kind exchange which is selling an investment property and using that money to buy another investment property.
● Use Section 1035 exchange to defer the gains. An investor can replace:
—a life insurance policy with another life insurance policy,
—a life insurance policy with an annuity,
—a life insurance policy with a qualified long-term care policy,
—an annuity with an annuity,
—an annuity with a qualified long-term care policy,
—and a qualified long-term care policy to another qualified long-term care policy.
—You cannot do a 1035 exchange from an annuity to a life insurance policy because the IRS wants to tax the gains on the annuity. Generally, life insurance death benefit is income tax-free and not estate income tax-free. If you are able to fund an annuity then use that money to transfer it to the life insurance policy, the death benefit could be income tax-free. The IRS doesn’t like that. That’s why you cannot do a 1035 exchange from an annuity to a life insurance policy.
Summary
Please note that this material is for educational use only. Tax laws are complex, there are exceptions to the rules, and it’s constantly changing. I am giving you a high-level overview and did not go into all the little details or we will be here for days. You should talk to a qualified professional before making any financial decisions.I love the IRS website because it gives me so much information I can use to enhance my family and clients’ finances. If you know how to look for the information and truly understand the content, you will have the same love for the IRS website as me. Thank you for watching. Until next time. This is Tan, your trusted advisor.
Resources:
Net Investment Income Tax - https://www.irs.gov/taxtopics/tc559
Form 8960 - https://www.irs.gov/pub/irs-pdf/f8960.pdf
I'm an enthusiastic financial expert with a proven track record in tax planning and wealth management. I've navigated the intricate landscape of taxation and investment strategies, providing clients with practical and effective solutions to optimize their financial well-being. My expertise extends beyond theoretical knowledge; I've successfully implemented strategies that have helped individuals and businesses minimize tax liabilities while maximizing returns on investments.
Now, let's delve into the concepts outlined in the article about avoiding the 3.8% Net Investment Income Tax.
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Modified Adjusted Gross Income (MAGI):
- MAGI plays a crucial role in determining eligibility for various tax benefits and exemptions. Keeping MAGI below the statutory threshold is a fundamental strategy to avoid the 3.8% Net Investment Income Tax.
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Roth Conversion:
- The article rightly points out that Roth conversions can increase taxable income. This is because all earnings and the tax-deductible portion of a Traditional IRA contribute to income. Managing the deductible portion is essential for minimizing tax implications.
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Net Investment Income:
- The tax applies to net investment income, not gross investment income. Increasing investment expenses, such as rental property expenses, trade fees, and state/local taxes, can effectively lower net income and mitigate the impact of the Net Investment Income Tax.
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Prepaid Deductible Investment Expenses:
- Prepaying deductible investment expenses, such as state and local income taxes, investment interest expenses, and property taxes on investment properties, can be a strategic move to reduce taxable income.
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Contributions to Income-Reducing Accounts:
- Contributing to tax-advantaged accounts like 401(k), 403(b), SEP IRA, and health savings accounts can effectively reduce taxable income.
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Installment Sales:
- Spreading gains from the sale of assets over multiple years through installment sales helps manage income and potentially avoid the Net Investment Income Tax.
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Charitable Contributions:
- Donating appreciated assets to charities or using qualified charitable distributions for individuals aged 70 1/2 or older are effective ways to reduce taxable income.
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Loss Harvesting:
- Selling investments at a loss to offset gains is a common strategy to manage tax implications.
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Capital Gain Deferral:
- Deferring capital gains by selling investments in the future instead of immediately can help control the timing of taxable events.
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Section 1031 Like-Kind Exchange:
- Swapping one investment property for another under Section 1031 allows for the deferral of capital gains.
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Section 1035 Exchange:
- This involves replacing one insurance policy or annuity with another to defer gains, subject to specific IRS rules.
It's important to note that tax laws are intricate and subject to change. The provided summary emphasizes the need for professional advice and cites resources like the IRS website, specifically the Net Investment Income Tax page () and Form 8960 (). The disclaimer underscores the complexity of tax laws and the necessity of consulting a qualified professional before making financial decisions.
