But many types of investment income are subject to unfavorable tax rates when they’re reported by high-income clients. Not only can basic tax rates be higher (up to 39.6% on ordinary income, and 20% instead of 15% on dividends and long-term gains), net investment income can also be subject to a 3.8% surtax designed to help finance Medicare. Without counting any state taxes, high-income clients could owe 43.4% on interest income as well as 23.8% on dividends and long-term gains.
“Planning to minimize the surtax can run into problems,” says Scott Cramer, president of Cramer & Rauchegger, a retirement and estate planning firm in Maitland, Fla. “One approach is to invest in growth stocks that pay little or no dividends and avoid taking profits. In the current environment, however, many clients want investment income, which can be subject to an extra 3.8% tax.”
Surtax planning must deal with complexity, too. This tax is imposed on single taxpayers with modified adjusted gross income over $200,000 and on married couples with MAGI over $250,000. Over those thresholds, the 3.8% surtax is imposed on (a) net investment income or (b) the MAGI over the relevant threshold, whichever is smaller.
In terms of portfolio construction, what can advisors do to hold down investment income and thus abate the surtax pain for key clients? One possibility is to invest in municipal bonds, as tax-exempt interest is also surtax-exempt. But, Cramer cautions against buying long-term munis to get relatively high yields now. “We think long-term bonds are very dangerous,” he says. “If interest rates rise, they’ll lose value.” Muni investors might focus on short- and medium-term issues, but yields are scant today.
Cramer sees a role for deferred annuities in surtax planning. “We’ve mainly been using fixed index annuities, along with some variable annuities,” he says. Taxable distributions from these annuities are subject to the surtax, but such distributions might be deferred into years when the client is in a lower tax bracket and income may not top the surtax threshold. Fixed index annuities generally have a floor against losses while offering some participation in stock market gains.
Otherwise, harvesting losses in taxable accounts may hold down surtaxable income, Cramer says. “We might include nontraded private REITs and master limited partnerships in the portfolios of clients who seek income,” he adds. Both REITs and MLPs tend to have relatively high payouts, partially untaxed (and unsurtaxed) as a return of capital. Investors’ basis is reduced, but the resulting higher tax bill on a sale may be deferred to a better time.
For many of his clients, Cramer recommends dividend-paying stocks, which can offer appealing yields and growth potential. Those yields are subject to the surtax but can still qualify for favorable tax treatment, in most cases. In a quirk of tax law, some high-income clients will owe the 3.8% surtax on dividend income but, as long as taxable income is less than $406,750 ($457,600 for couples filing jointly), they’ll pay tax at only 15% on qualified dividends, keeping the total federal tax rate to what might be a still-attractive 18.8%.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.