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Mitigating Surtaxes Faced by High-Income Earners

Thoughtful, proactive planning can help high-earning taxpayers reduce their net investment income tax and additional Medicare tax bills.

Every investor should have a thoughtful tax strategy, and for those that exceed certain income thresholds, proactive planning is all the more important.

Individual taxpayers with modified adjusted gross income (MAGI) of $200,000 face a 3.8% net investment income tax on the lesser of their net investment income amount or the amount by which their MAGI exceeds that $200,000 threshold. For couples filing jointly, the threshold is $250,000. These taxpayers are also subject to a 0.9% additional Medicare tax on wages and self-employment income over the same amount.

Talk to your financial advisor, along with your accountant or tax advisor, to identify and implement the strategies that are most advantageous for your situation.

Here are some options to consider.

Improve your portfolio’s tax efficiency

To get a sense of your annual tax liability, review your portfolio’s turnover ratio (the percentage of your holdings that have been replaced in a given year) and historical distributions. Then, work with your advisor to evaluate your investments, review your after-tax returns and consider opportunities to improve efficiencies.

Steps that may help to reduce taxes include tax-loss harvesting – selling securities at a loss to offset capital gains taxes – and rebalancing your portfolio to include more tax-advantaged investments, such as municipal bonds, in higher-taxed locations.

Capitalize on employer benefits

If your employer offers a salary deferral plan like a 401(k), SIMPLE IRA, 403(b) or 457 plan, maximize your contributions to reduce your adjusted gross income and taxes over the long term. Similarly, if you’re eligible, maximize contributions to an employer Supplemental Employee Retirement Plan (SERP) to reduce your taxable income now and defer the compensation into later years when your tax rate may be lower.

Another often-overlooked benefit is an employer health savings plan or flexible spending account. Contributions use pre-tax dollars, reducing your taxable income.

Develop a charitable giving plan

Charitable giving can reduce your tax burden while benefitting your favorite causes. Consider:

  • Giving appreciated securities to avoid capital gains, which increase your net investment income
  • Bunching several years’ worth of donations into one year to exceed the standard deduction, making itemizing advantageous, and taking the standard deduction in the years that follow
  • Establishing a donor-advised fund to make future donations and claim the current income tax deduction
  • Contributing highly appreciated assets to a charitable remainder trust (CRT) to defer recognition of income over time

While these tax planning strategies may help you to reduce your overall tax bill, don’t lose sight of your risk tolerance and long-term financial goals.

The process of rebalancing may result in tax consequences. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. Profits and losses on federally tax-exempt bonds may be subject to capital gains tax treatment. In addition, certain municipal bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax. Withdrawals from qualified accounts may be subject to income taxes, and prior to age 59½ a 10% federal penalty tax may apply.