Wednesday, September 17, 2014

Strategies For Mitigating The Net Investment Income Tax: Reducing MAGI and AGI


Remember that a key consideration when exploring planning strategies for mitigating a taxpayer’s NIIT liability is to determine whether the NIIT would be imposed on a taxpayer’s Net Investment Income (NII) or excess Modified Adjusted Gross Income (MAGI) (or UNII (undistributed Net Investment Income) versus excess AGI (Adjusted Gross Income) for trusts and estates). If the NIIT would be imposed on excess MAGI or AGI, opportunities to reduce or defer any type of income should be explored. The following are several recommended strategies for reducing a taxpayer’s MAGI or AGI amount.

Roth IRA Conversions.
Unlike other qualified retirement plans, Roth IRAs have no minimum required distributions, and their withdrawals are tax-free. These qualities make Roth conversions an effective strategy for reducing a taxpayer’s AGI/MAGI over the long term. However, Roth IRA conversion income is considered taxable income and thus increases MAGI. Therefore, when suggesting Roth conversions as a planning strategy, planners should consider the cost and benefits of a Roth conversion including the following:

The current tax rate
Future tax rates
The availability of funds to pay income tax on the conversion
The client’s time horizon
This strategy might be most effective for clients who expect their income to exceed threshold amounts later in retirement due to Social Security benefits and required distributions from other qualified plans.

Charitable Giving.
Charitable planning is useful tool for reducing MAGI, especially the following three methods: (1) gifts to charities, (2) charitable remainder trusts (CRTs), and (3) charitable lead trusts (CLTs).

Direct Gifts to Charities. Gifting directly to a charity may cause an immediate charitable income tax deduction, resulting in a reduction in the donor’s MAGI.

Charitable Remainder Trusts. CRTs allocate a portion of net income as interest income received by the beneficiaries and then release the remaining portion to a charity. This also creates an immediate charitable income tax deduction on the portion released, which can be used to off set NII. CRTs are particularly significant as a planning strategy since they are tax-exempt entities. This means the trust has the option to sell contributing assets tax-free and reinvest the profit elsewhere. The trust’s income is spread out over annual payments throughout the trust term, helping to keep the beneficiary’s MAGI below the threshold. However, beneficiaries may still be subject to NIIT when they receive distributions.

Nongrantor Charitable Lead Trusts. CLTs behave like CRTs in reverse in that instead of a certain amount of income initially allocated to the trustee, a portion is allocated to a charity, with the remainder passing to noncharitable beneficiaries at the trust’s termination. The CLT receives a deduction for each annual distribution to the charitable beneficiary, some of which can be allocated to its NII. In essence, the CLT off sets NII against charitable deductions, so that such investment income is no longer taxable to the donor. This strategy is typically only effective for high net worth clients who can afford (and desire) to make generous contributions to charities.

Installment Sales.
Installment sales offer another planning opportunity for reducing a taxpayer’s MAGI. In an installment sale, the payment for the asset is spread out over a period of years rather than received as a lump sum. This in turn stretches capital gains and taxable MAGI across multiple years, allowing taxpayers to more easily remain below the NIIT threshold amount.

Above-the-Line Deductions and Exclusions.
One of the easiest ways to decrease taxable income is to increase “above-the-line” deductions that will reduce AGI and MAGI. Common above-the-line deductions and exclusions include the following:

Contributions to qualified retirement plans and IRAs
IRA deductions
Health Savings Account (HSA) and Flexible Spending Account (FSA) deductions
The deductible portion of the self-employment tax
Student loan interest deduction
Moving expenses
Deferred compensation

While regulations for the NIIT have been forthcoming, as previous posts have shown, there are still several areas that require guidance. Moving forward, it is important for both planners and clients to keep in mind that the NIIT is still fairly new, and consequently, effective planning strategies for mitigating the tax are still developing.