Jason: Higher-income investors and taxes
As a result of new tax-law changes that went into effect in 2013, high-income investors now need to understand how their investment choices can impact their taxes.
This is the first year that the new net investment income tax takes effect. The tax, which also is known as the Medicare tax on investment income or NIIT, sits on top of both capital-gains taxes and income taxes, and is one of the changes that will affect higher-income investors at tax time. Another change is the increase in the highest rates that apply to long-term capital gains and qualified dividends (15 percent to 20 percent).
NIIT affects taxpayers whose adjusted gross income (AGI) exceeds $250,000 for married taxpayers filing jointly and surviving spouses; $125,000 for married taxpayers filing separately; and $200,000 for unmarried taxpayers and heads of household. You'll find AGI at the bottom of Page 1 of Form 1040. AGI is generally gross income before exemptions and deductions.
The typical investor will need to understand taxes on capital gains, interest and dividends, all subject to NIIT, as well as IRA withdrawals and tax-exempt interest, which are not subject to NIIT, according to Scott Weiner, senior tax analyst at Thomson Reuters.
To see the effect of taxes on investment income, let me compare five scenarios using Thomson Reuters' Checkpoint research platform. I'll use $300,000 of income for a single filer generated solely from the source shown.
1 • Tax-Exempt Interest. Income of $300,000 generated entirely from tax-exempt interest creates a tax bill and an NIIT of zero.
2 • Traditional IRA. A $300,000 withdrawal from a traditional IRA (with no basis) results in a tax of about $80,000 for an effective rate of 27 percent, with no NIIT. Roth IRA withdrawals do not trigger NIIT, or income taxes, as long as the withdrawals meet certain requirements.
3 • Taxable Interest. If the $300,000 of income is entirely taxable interest, taxes come to about $84,000, including an NIIT of $3,800 (3.8 percent of $100,000, the difference between $300,000 and $200,000, the threshold for NIIT for a single filer).
4 • Qualified Dividends. If the $300,000 is generated by qualified dividends, the tax bill is only $42,000 with an effective tax rate of 14 percent. This includes an NIIT of $3,800.
5 • Long-Term Capital Gains. This tax bill on $300,000 of long-term capital gains is the same as for qualified dividends: $42,000, which includes the NIIT of $3,800.
Keep in mind that some gains are not taxable at all, such as up to $250,000 of gain on the sale of a principal residence ($500,000 for a married couple). If the gain exceeds these limits, NIIT will come into play. Gains on the sale of qualified small-business stock are excluded from NIIT, according to Weiner.
If you're thinking about increasing your itemized deductions, such as charitable contributions, to reduce your NIIT, that won't work. As I mentioned, AGI is calculated before subtracting itemized deductions.
Be sure to review your tax situation with your accountant before taking any action based on these changes. For more information on Thomson's resources, including Checkpoint, go to thomsonreuters.com.
Julie Jason, JD, LLM, a personal money manager (Jackson, Grant of Stamford, Conn.) and award-winning author, welcomes your questions/comments (firstname.lastname@example.org).