A 3.8 percent surcharge on net investment income contained in the Patient Protection and Affordable Care Act will create extra homework for advisors this year as they figure out which assets to sell through tax loss harvesting.
The tax, known as the Net Investment Income Tax (NIIT), took effect Jan. 1, 2013. It applies to net investment income above a modified adjusted gross income (MAGI) amount of $200,000 for individuals and $250,000 for married couples filing jointly.
“Investors that don’t pay close attention to their MAGI and net investment income could be subject to higher taxes,” said Jamie Hopkins, associate director of the retirement income program at the American College of Financial Services in Bryn Mawr, Pa.
Tax loss harvesting, or the idea that investment losses offset gains, lowers taxable income and that means forking over less to Uncle Sam.
“Remember, you don’t want to pay more in taxes than you have to,” Hopkins said.
Though a popular tool for maximizing after-tax returns, not everyone is enamored with tax loss harvesting. Some advisors say selling stocks and bonds that are out of favor only to buy them back later amounts to little more than a tax deferral.
Subtract trading commissions and the investment opportunities lost by moving into cash and suddenly tax loss harvesting doesn’t seem so shrewd.
“Tax loss harvesting flies in the face of the most fundamental rule of investment, which is to buy low and sell high,” said Jonathan Citrin, founder and chief compliance officer of Citrin Group, in an October interview with CNBC.
Tax loss harvesting strategies typically involve mutual funds and individual securities that underperform, as many do every year. This year, China took a beating and oil company stocks suffered as prices collapsed.
But tax loss harvesting can also be applied to life insurance policies and annuities via a 1035 exchange, Hopkins said.
“This is all about taking advantage of the amount you have paid into the policy compared to the cash value of the policy — if you have paid a lot into the policy but your cash value or surrender value is lower, you could transfer the policy to an annuity and offset future taxable gains in the annuity,” Hopkins said in an interview with InsuranceNewsNet.
Generally, though, tax loss harvesting on longer duration life insurance contracts and annuities is less frequent than on shorter-duration investments.
Few joint tax filers make as much as $250,000. So for tens of millions of taxpayers, Medicaid surcharges and tax loss harvesting, which affects income outside of tax advantaged accounts, isn’t something they are worried about, Hopkins said.
But with employees stashing trillions of dollars away into individual retirement accounts (IRA), Simple IRAs, SEPs and employer-sponsored 401(k)s, the conversion to Roth IRAs affects a lot more people and the experts who advise them.
“You can get almost every single advisor interested in talking about a Roth IRA since people ask their financial advisor if they should contribute to a Roth IRA or traditional IRA,” Hopkins said.
“It also plays a huge role in the 401(k) rollover world as the government is placing a lot of attention on this area with recently proposed regulations from the Department of Labor on expanding the fiduciary standard,” he added.
Roth IRAs, which offer tax-free growth, are more attractive to investors who prefer paying taxes today — taxes that are presumably lower in the early part of a working career — as taxes rise when employees earn more.
For most people, the traditional IRA makes more sense because it lowers a worker’s tax bracket during the prime contribution years. In retirement, when a worker no longer earns what he or she used to, it’s better to pay taxes later than in the prime of a working life.
The question with IRAs often revolves around whether contributions are deductible or not, and whether a Roth IRA presents a more attractive option.
“Good advisors should be looking at the income implications for a client’s down year,” Hopkins said.
Suppose you are in sales and have come up short of plan in 2015, then it’s worth converting part of a traditional IRA to a Roth IRA and take advantage of a lower tax rate.
“Also, make sure you convert the whole account and pay taxes from the outside of the account because $5,500 in a Roth IRA will be worth more than in $5,500 in traditional IRA,” he said.
With the country in a generally rising tax rate environment to pay for government spending, it’s worth putting funds into a Roth IRA, a traditional tax-deferred vehicle and even a brokerage account, which amounts to a tax diversification strategy, Hopkins said.
“We went to minimize that risk of putting all your retirement assets into one type of account,” he said.
For the very wealthy, Roth IRAs are good because investors avoid required minimum distributions at 70.5 years required under a traditional IRA.
“With a Roth account, everything in it is all yours, but with the traditional IRA, the government still owns a claim on it in the form of taxes. For some people the Roth IRA brings peace of mind,” Hopkins said.
InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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