MAGI is adjusted gross income plus the client's net foreign earned income exclusion.
Net investment income includes many things. In the mix are taxable interest, dividends, annuities, rents, royalties, income from a passive activity, income from trading in financial instruments or commodities, and capital gains on non-business property such as portfolio securities or a second home. When profits on a principal residence top the tax-free amount ($500,000 for joint filers, $250,000 for singles), the taxable portion counts toward net investment income.
Because the surtax is assessed on the smaller of two figures, if either is zero, there is no surtax.
There exist but two ways to reduce, or increase the surtax: either change net investment income or change excess MAGI, which, in some slightly circular math, includes net investment income plus other income. One approach may have greater impact on the surtax than the other, depending on the facts.
Suppose a client with $50,000 of net investment income exceeds the MAGI threshold by $80,000, as Example 1 in the chart depicts. Reducing other income by $15,000 would lower the excess MAGI to $65,000, but the smaller investment income of $50,000 would continue to dictate the surtax. Other income would have to decrease by more than $30,000 to lower the tax, whereas any reduction in net investment income would do the trick.
What if income rises? When investment earnings drive the surtax, if it grows, so does the levy. "But you could add other income and it wouldn't affect the surtax," says Mitchell Drossman, the Manhattan-based national director of wealth planning strategies for U.S. Trust.
To manage investment income, shift from taxable bonds to municipal debt, says Leon LaBrecque, CEO of LJPR LLC, an independent wealth-management firm in Troy, Mich. Muni income is not subject to the surtax, LaBrecque says.
Or you might seek investments providing tax shelter, such as tax-deferred non-qualified annuities, real estate (when the rental income is offset by depreciation deductions), and cash-value life insurance, says CPA Robert S. Keebler, partner at Keebler & Associates LLP in Green Bay, Wis. Non-modified endowment contract insurance policies can provide clients with tax-free cash flow via policy loans and non-taxable basis recovery, Keebler points out.
Clients who take gains this year will need to carefully weigh installment sales, cautions LaBrecque. An installment sale spreads the gain into future years, which could be detrimental if the tax rate will be higher then. Clients with existing installment sales might consider negotiating an accelerated payment in order to realize gains ahead of 2013. "We've discussed that with clients," says LaBrecque.
Different Situation, Different Strategies
Now consider Example 2, someone with $150,000 of investment income and $100,000 excess the MAGI. With excess MAGI controlling the surtax, it can be reduced by lowering either of MAGI's constituent parts: investment income or other income. Likewise, increases in either type of income swell the surtax bill.