If your income falls into the range that labels you as “wealthy” in the eyes of the federal government, there is not a lot you can do to avoid getting socked with the Net Investment Income (NII) or additional Medicare tax.(1) Nonetheless, there may be ways to at least reduce the impact--but you have to plan ahead.
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While you’re probably familiar with the term “asset allocation,” a more recent concept is “asset location.” While the former is aimed at reducing the risk in your portfolio, the goal of the latter is to reduce the taxes you pay on your investments by carefully considering which accounts offer the best after-tax return for different types of securities.
Take equities, for instance. Whether you own individual shares or are invested via mutual funds, stocks can generate both taxable capital gains as well as ordinary income in the form of dividends.
“We saw a lot of capital gains distributed last year because the stock market was up,” says John Sweeney, head of retirement and investing strategies at Fidelity Investments. For instance, say your mutual fund manager sold some appreciated stock in order to re-balance the holdings in the fund or you sold some individual shares in order to cover your child’s first term in college. In either case, a capital gain was generated, and as a result, says Sweeney, “You may find that you are subject to the new 3.8% investment income surtax.”
Any interest you earn on taxable bonds or CDs is also added to your ordinary income--a move that could potentially make you subject to one or both of these new taxes.
Give Long-term Investments Shelter
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No one’s recommending that you stash your money in a can buried in your backyard in order to avoid capital gains and income. Instead, says Sweeney, you want to consider not just what investments you own, but where you own them. “If you own investments that generate income or capital gains, these might be best inside a tax-sheltered account such as a 401(k).”
That’s because until you take a withdrawal, you don’t pay any tax on any of the appreciation, dividends and interest earned by the investments in this type of account. And presumably you'll make that move once you are retired and no longer earning a salary. Because the additional 0.9% Medicare tax only comes into play if you have wages, once you’re retired, this will no longer be a factor. In addition, you will likely be in a lower tax bracket. So, even though the income you withdraw from your retirement account will be taxable, it probably won’t push you above the threshold where the NII kicks in.
What’s Your Timeframe?
Still, as they say, you don’t want the tail (taxes) to wag the dog (your portfolio). Karen Goodfriend, a CPA and personal financial specialist (PFS) in Los Altos, Calif., says looking at the tax consequences of where you hold various types of investments is simply a place to start. “It gets complicated because not all of your portfolio is used at the same time for the same purpose,” she points out. “For instance, if you are saving money to buy a new house in a couple of years, that [money] will go into a taxable account” as opposed to a tax-sheltered account such as an IRA.
In other words, in addition to the tax consequences of where you hold your assets, you also have to consider how long they will be invested. If your time horizon for using the money is short term--say, a year or two--you don’t want to put it into an account that carries a government penalty if you withdraw it before you reach a certain age or before it has been in the account for a minimum length of time. In addition, money you plan to use in a few years should be invested in securities with low risk (which generally also means a lower potential return) so that you can count on it being there when you need it.
In this type of situation, Goodfriend suggests using a taxable account holding a mix of short-term bonds and cash. To reduce the tax consequences, she recommends a combination of municipal bonds and a tax-free money market account.
Sweeney points out that if you want to own equities in a taxable account and are in a higher bracket, consider either owning individual stocks- which gives you control over when gains are generated- or mutual funds that are managed to minimize taxes. Some managers do this through a combination of controlling turnover and offsetting gains and losses within the fund itself.
Keep in mind that if an investment is held in a taxable account, such as a brokerage account, you also need to keep track of when you purchased it. To avoid having a gain being subject to the much higher ordinary income tax rates, you must hold the security for more than a year before you sell it.
Fidelity’s Sweeney also points out that if are investing in a mutual fund that is not inside a tax-sheltered account, you should also ask whether the fund is expecting to pay out a distribution soon. Typically, this occurs near the end of the year. “You don’t want to buy a mutual fund just before it pays a distribution. If you do, you are paying for that gain, but not getting the advantage of it.”
Sell Your Losers
Everybody hates to admit that an investment didn’t work out the way they had hoped. That’s why we hang on to our losers far too long. Even if a security has been in the red since early in the year, typically, most of us wait until December before we even consider dumping it. The experts say that’s the wrong approach.
If it makes you feel any better, tell yourself that by selling your losing investment, you’re giving yourself a gain in terms of taxes. “Tax loss harvesting is something that should be done throughout the year,” according to Goodfriend. Waiting until the end of the year can result in lost opportunities. As Sweeney points out, “The market was down in the third quarter and up in the fourth quarter [of last year]. Take advantage of losses when you can.”
Even if you don’t have any gains to immediately offset, remember that losses can be carried forward to offset gains in future tax years. If you’re convinced your loser has potential, you can always buy it back. Just wait 31 days to avoid the “wash sale rule.” If you don’t want to wait that long, you can immediately buy something similar--such as a bond with a different maturity from the same issuer or the stock of a company in the same industry.
“People tend to focus on regular tax rates,” says Goodfriend. And despite recurring Congressional threats to kill the Alternative Minimum Tax, it is still alive and well. The AMT generates too much income for Washington to give up.
Like the regular income tax, your potential to be affected by this parallel tax system is also affected by the timing of when you take deductions and income. According to Goodfriend, it’s more important than ever not to rely on rough estimates of what your income will be. “Ballpark numbers can be dangerous,” she says.
Take A Smoothie and Call Me in the Morning
If you fall into one of the top brackets, you’re making a mistake if you only focus on the current year. Instead, you should be doing multi-year planning so that, to the extent possible, you can avoid having your income spike and put you over the threshold that makes you subject to the extra 0.9% Medicare tax or the 3.8% investment income tax.The goal is to smooth out your income.
For instance, suppose you know you’re going to be taking maternity leave or quitting your job in order to attend graduate school next year. Can you shift some of this year’s income by electing to receive your bonus in 2015? Granted, not everyone has this kind of flexibility, but if you are a business owner, you probably have significant control over when you book your income.
You also want to look at the timing of capital gains. If you plan to retire this year you might want to consider postponing the sale of an investment until 2015 because your income will be lower. This could reduce the chance you’ll get snagged by the Net Investment Income tax.
Taxes Aren’t Everything
As previously mentioned, you don’t want to let fear of taxes run your investment decisions. Sometimes you need to bite the bullet for the sake of improving the return or reducing the risk of your overall investment mix.
For instance, imagine that thanks to an inheritance, stock in a single company makes up 35% of your portfolio. No matter how well run you think Uncle Alfred’s former employer is, that’s putting way too many eggs in one basket. “If the stock needs to be sold to diversify your portfolio, it might be worth” taking the tax hit, says Goodfriend.
It Might Be Time to Roth-ify
If you own a traditional (tax-deductible) IRA, consider converting a little bit each year to a Roth IRA. Some or all of the amount you convert will be subject to ordinary income tax rates, but the long-term benefit can outweigh this, especially if you think you will still be in a high tax bracket when you retire. Once inside a Roth. your investments grow tax free forever. Added bonus: Roth withdrawals do not factor into the equation that determines how much of your Social Security benefit is subject to income tax.
“It takes number crunching,” warns Goodfriend, whose clients include various Silicon Valley alumni. If you’re in a low-income year because you were laid off, got bought out, or are just taking a sabbatical before launching the next Facebook (FB), “you need to run a tax projection to estimate the size of the Roth conversion you should do.”
Remember, if your situation changes, you have the flexibility to undo a Roth conversion as late as Oct. 15 of the next year by “recharacterizing” back to your traditional IRA.
The bottom line is that if you are in one of the upper income brackets, your taxes have gone up- significantly. Your deductions have gone down. “Beating the system” is harder than ever. You’ve got seemingly conflicting goals to balance: growing your assets, controlling risk, financing your lifestyle, minimizing taxes. Consider getting help from competent professionals who can help you determine your best multi-year strategy.
1. The additional 0.9% Medicare tax applies once your income from a job (“wages”) exceeds a certain amount:
|Married filing jointly||$250,000|
|Married filing separate||$125,000|
|Head of household (with qualifying person)||$200,000|
|Qualifying widow(er) with dependent child||$200,000|
The additional 3.8% Net Investment Income tax applies if: a) you have net investment income, and 2) your modified adjusted gross income exceeds the following thresholds. Note that with the exception of “qualifying widow(er) with dependent child,” these are the same dollar amounts as above.
|Married filing jointly||
|Married filing separately||
|Head of household (with qualifying person)||
|Qualifying widow(er) with dependent child||
Note: the thresholds for both new taxes are not indexed to increase with inflation.