2014 marks the second year that many high-income clients will be hit with the 3.8 percent investment income surtax that's part of the Affordable Care Act, but it could come as a very nasty surprise to clients who find themselves subject to that provision for the first time, warns Chad Smith, a wealth management strategist at HD Vest Financial Services.

For the vast majority of affected clients, there's not much you can do to help besides giving them a heads-up prior to delivering their 1040 for review -- though a handful of self-employed clients may still be able to escape or blunt the net investment income tax's impact for 2014 - but it's not too soon to work with all of your clients to minimize the hit for 2015.

The surtax on investment income applies to taxpayers with modified adjusted income above $250,000 for married filing jointly taxpayers, and $200,000 for single filers. These thresholds are not inflation-indexed.

The 3.8 percent surtax applies to:

  • Taxable interest;
  • Qualified and non-qualified dividends;
  • Short- and long-term capital gains;
  • Annuity income (unless the annuity is held in a qualified retirement plan); and,
  • Income from passive activities (e.g., most forms of rental income).

The two primary categories of investment income not subject to the tax are exempt interest (e.g., municipal bonds) and distributions from a qualified plan, including those coming from an annuity contract.
Perhaps the only potential "loophole" remaining to reduce a taxpayer's exposure to the surtax for 2014 after Jan. 1, 2015, applies to self-employed taxpayers who maintain a SEP plan. The deadline for making deductible contributions to SEPs is the taxpayer's filing deadline, including extensions, so they might avoid some of that 3.8 percent hit by maximizing SEP contributions.



For the rest, it's not too soon to prepare for next year with several planning tactics, according to HD Vest's Smith:

  • Shift to munis. Like taxable bonds, munis are subject to interest rate risk. And although munis are issued by state and local entities, their investment risk can vary considerably; municipal defaults, while rare, do occur (witness Detroit). Still, other things being more or less equal, a heavier allocation to munis for clients' fixed-income portfolios can help.
  • Portfolio analytics. Beyond the muni-vs.-taxable bond allocation question, you can review whether assets are optimally allocated within qualified and taxable accounts. For example, a taxpayer's growth-oriented securities, ultimately subject to capital gains, make more sense in a taxable account, and income-oriented ones in a qualified plan. This will not directly impact the taxpayer's liability for the 3.8 percent surtax, but reduces the tax bill that the taxpayer would pay even in the absence of the surcharge.
  • Mutual funds with large embedded capital gains. Buying fund shares when the fund will soon make a capital gain distribution unnecessarily accelerates the timing of the tax liability associated with that investment.
  • Purchase individual stocks. Not all investment accounts are suitable for individual stock purchases, but owning individual securities (including ETF shares) allows flexibility for the timing of recognition of gains -- and losses.
  • Maximize qualified plan options. This applies to corporate employees, as well as the self-employed. Some business owners or partners in professional practices might have a vastly greater opportunity to shelter income by starting a defined-benefit pension. Permissible deductions (subject to some limits) are based on amounts needed to fund a particular benefit at retirement. Thus the older the individual, the higher the permissible deduction. For example, a 55-year-old plastic surgeon with $800,000 in W-2 wages would be limited to $57,500 in contributions (including catch-up contributions) to a defined-contribution plan, such as a 401(k). In contrast, they could contribute $208,700 to a defined-benefit plan, or $247,300 if done in conjunction with a defined-contribution plan contribution. That would reduce the taxpayer's incremental 3.8 percent tax bill on investments by more than $16,000.
  • Review gifting strategy. A client might have planned to start gifting stock from his taxable portfolio to children or charities in a few years. But if faced with an added 3.8 percent tax liability associated with owning some stocks and bonds, it might be appropriate to accelerate the gifting plan.

In the end, there is only so much you can do to shield your clients from the long arm of the IRS. But suggesting ways to go about it, and implementing them when agreed upon, helps your clients and therefore strengthens the relationship.
The views and opinions presented in this article are those of Chad Smith and not of HD Vest Financial Services or its subsidiaries.

For more information about HD Vest Financial Services and how they can help you transfer a client’s wealth, visit hdvest.com/taxalpha9 or contact a Business Development Consultant at (800) 742-7950.

HD Vest Financial Services® and its affiliates (collectively, “H.D. Vest, Inc.”) do not provide tax or accounting services. You should consult your tax professional regarding the tax implications of any investments.

HD Vest Financial Services® is the holding company for the group of companies providing financial services under the HD Vest name.
Securities offered through HD Vest Investment ServicesSM, Member SIPC, Advisory services offered through
HD Vest Advisory ServicesSM, 6333 N. State Highway 161, Fourth Floor, Irving, TX 75038, 972-870-6000.

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