As this article is being written, spring has just sprung and the annual rite of “talk about tax reform” has begun on Capitol Hill.
The lodestone of tax reform is to clean up the Tax Code by removing behavior-altering incentives that induce tax-preferred actions rather than market-oriented market activity. In other words, close the loopholes, and let economic decisions be driven by nontax forces.
However, the Tax Code is not the only source of potential economic distortion. While the tax rates for capital gains rose in January, incentives to prefer some investments over others also arise from the sources, most notably the implementation of the Patient Protection and Affordable Care Act, popularly known as “ObamaCare.” The PPACA imposes a new tax, the “net investment income tax” or NIIT, which applies at a rate of 3.8% of the net investment income of individuals, estates and trusts with income above certain statutory amounts. For individuals, the threshold amounts are:
- $200,000 for single taxpayers;
- $250,000 for married individuals filing jointly; and
- $125,000 for married individuals filing separate returns.
The threshold amounts include all income, even income not subject to the tax; however, investment income is subject to the tax if only the taxpayer’s total income exceeds the threshold.
As it says, the NIIT applies only to “net investment income.” In general, investment income includes interest, dividends, capital gains, rental and royalty income, certain annuities, and income from businesses that are passive activities. Net investment income is investment income reduced by expenses properly allocable to the income. Gains included in the calculation include gain from the sale of stocks, bonds and mutual funds, capital gain distributions from mutual funds, gain from sale of investment real estate, and gains from the sale of partnership and S corporation interests.
The NIIT is based on the lesser of 1) the amount by which the taxpayer’s “modified adjusted gross income” (MAGI) exceeds the threshold or 2) the taxpayer’s net investment income. For example, if a single taxpayer has $180,000 in wages and $90,000 in net investment income, the tax is computed on $70,000, the amount by which income exceeds the $200,000 threshold amount. The taxpayer would owe net investment income tax of $2,660 ($70,000 x 3.8%).
As with every change in the tax laws, whether in the Internal Revenue Code or elsewhere, this brings up a whole new range of tax planning techniques. For starters, if a taxpayer will likely be under the threshold in a particular year, planning will focus on increasing NII to utilize the full amount of the threshold. Thus a person might accelerate the realization of income on the sale of stock which she might otherwise have retained for further appreciation. Timing the recognition of capital gains will allow taxpayers to control both their MAGI and the NII, and matching capital gains with capital losses will take on greater importance. A taxpayer who might otherwise require immediate payment on the sale of a business interest might now prefer to have payments made in installments to avoid a large spike in MAGI in the year of sale and to allow better control of the amount of NII realized each year thereafter.
What about the nature of investments themselves? Tax exempt interest is specifically excluded from the definition of NII, thus increasing the attraction of the municipal bond market.
Investments that defer inclusion in MAGI for extended periods of time will likely be used more extensively. These include annuities and growth stocks.
Retirement planning will also be viewed differently, since distributions from retirement vehicles such as 401(k) plans and IRAs are specifically excluded from the definition of NII.
And there is yet another form of investment that suddenly becomes startlingly more attractive than heretofore—namely, the purchase of whole life insurance policies, in fact, all insurance products, including universal life policies, that provide for a tax-free buildup of cash surrender values. The reason is that the inside buildup in the insurance products is included neither in MAGI nor NII. In addition, death benefits are not included either in MAGI or NII. Thus, under the PPACA regime, life products with inside buildup can now be more advantageous than investments in dividend paying stocks and stocks that generate capital gains.
In short, ObamaCare, regardless of its virtues or drawbacks in improving the American healthcare system, will likely have a major and recurring impact on Americans’ investment decisions.