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Retirement Planning > Retirement Investing

The tax planning tip that will prove an advisor's worth in 2014

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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.

As a result, for some clients, Roth conversions are best exercised in small steps over time — converting only a small portion of traditional retirement funds each year to avoid crossing the AGI threshold. For other clients, Roth conversions may no longer be the best option for generating tax-free income during retirement, especially if the client cannot balance the added income by contributing additional pre-tax dollars to traditional accounts because he has already maxed out the annual contributions.

For these clients, a cash value life insurance policy may be a better option. Contributing to these policies has no impact on a client’s current AGI but will create a tax-free retirement income source that is similar to a Roth account in the future. Once the policy is permitted to grow over a period of several years, the cash value in the account can be accessed through tax-free policy loans (which reduce the policy’s death benefit, but create a viable Roth alternative for those seeking to avoid the NIIT).

Required minimum distributions (RMDs) from traditional retirement accounts for clients age 70½ and older can also push AGI above the thresholds and this, in many cases, may be more difficult to avoid. For some clients, however, converting a portion of IRA (or 401(k)) funds to a Roth each year remains a viable option, depending on the client’s current AGI and ability to shoulder the additional income tax burden if he is no longer working (there is no age limit on a client’s ability to convert to a Roth).


The indirect application of the NIIT to retirement account funds may have caught many advisors and clients off guard in 2013, but with proper planning and structuring of investments, the tax hit can be minimized for 2014 and beyond.

For previous coverage of planning for the investment income tax in Advisor’s Journal, see The Investment Income Tax: Don’t Get Caught in the Passive Activity Trap.

For in-depth analysis of the tax treatment of IRA distributions generally, see Advisor’s Main Library:Income Tax Distributions.

Your questions and comments are always welcome. Please contact the Panel of Experts.


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