Net Investment Income Tax – A New Playing Field

R. David Fritz, Jr., CLU- Managing Partner, Founder

With the advent of the new net investment income tax (“NIIT”), there needs to be a change in thinking related to income tax planning arrangements and investments.

The new net investment income tax (“NIIT”) imposes an additional 3.8% tax on passive income received by individuals, trusts, and estates. When combined with higher income tax brackets, federal tax rates now can be as high as 43.4% on certain passive investment income. Tax planning and wealth management for clients now requires a shift to long-term deferred income tax planning. This includes considering use of life insurance, annuities, charitable planning, deferred compensation plans and other tax advantaged investments.

Planning to reduce taxes requires regular financial reviews with financial advisors and their clients, particularly for clients who are near the triggering income thresholds. Ideas for them to consider include:

  • Life insurance products, which enjoy tax-deferred status and generally do not impose a tax on unrealized gains on inside buildup and death benefits, will become more attractive with higher income taxes and the NIIT.
  • Higher taxes will also likely increase interest in deferred compensation planning for key executives and higher wage earners, with corresponding opportunities to use corporate-owned life insurance (COLI) to reduce the NIIT.
  • There is a “fresh start” election available to clients under the final treasury regulations which provide clients with a one-time opportunity to regroup their business activities to meet material participation requirements, thereby potentially reducing NIIT and other taxes.
  • Private placement annuities and life insurance may particularly appeal to higher earners and trustees who invest in hedge funds, commodity funds, or higher-yield taxable bonds. These clients may see returns from such investments consistently taxed at the highest income tax rates, but not receiving offsetting distributions to pay the taxes. Holding these types of investments through the investment account of a properly structured private placement insurance product can defer the gain recognition and the NIIT and also avoid the potential for phantom income.

As always, please seek the advice of your tax consultant to determine how the new net investment income tax will affect your personal situation. To learn more about strategies discussed above, please feel free to CONTACT an Executive Benefits Network consultant.