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
