As many clients learned firsthand during the 2013 tax season, the new 3.8 percent net investment income tax (NIIT), also known as the additional Medicare tax, has created new planning challenges that have not yet shown up on many advisors’ radar. In year one, this was perhaps unavoidable, as advisors and clients alike adjusted to the intricate set of circumstances that can trigger the tax, but planning to minimize the additional tax hit will prove an advisor’s worth in 2014. This is especially the case because the otherwise sensible retirement income-planning strategies employed by even the most tax-savvy advisors can actually create NIIT liability where none existed before.
The NIIT has added a layer of complexity to many of these retirement planning strategies. Now, additional steps or a combination with tax-preferred life insurance products may be key to producing smart tax results in 2014 and beyond.
Retirement income and the 3.8 percent tax trap
Officially, distributions from traditional retirement accounts (IRAs, 401(k)s) are excluded from the NIIT. Similarly, amounts that are rolled over into Roth accounts from these traditional accounts are technically excluded. These rules can cause clients and advisors alike to overlook the application of the NIIT when looking toward distributions and Roth conversions — an oversight that can prove costly.
The 3.8 percent tax on net investment income is imposed upon taxpayers with adjusted gross income (AGI) of more than $200,000 for single filers or $250,000 for married couples filing jointly. Once the client’s AGI exceeds these thresholds, the tax applies to the lesser of the taxpayer’s net investment income or to the amount by which taxpayer’s AGI exceeds the applicable ($200,000/$250,000) threshold.
While retirement account distributions (and Roth conversions) are excluded from the definition of net investment income, these amounts still count in determining a client’s AGI and can cause a client to exceed the applicable threshold and become subject to the NIIT.
New planning opportunities
The attraction of the tax-free distributions that Roth accounts generate has many clients flocking to convert traditional retirement funds to Roths in their pre-retirement days. However, Roth conversions will increase a client’s AGI by the amount converted, potentially subjecting the client’s investment income or a portion of AGI to the NIIT if AGI crosses the threshold.