The Net Investment Income Tax and How to Avoid It

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In 2013 a new income tax was added – the Net Investment Income Tax. This tax is an additional tax, at the rate of 3.8%, on investment income above certain levels. The Net Investment Income Tax (NIIT) is actually a Medicare surtax, intended to bolster the Medicare tax rolls in order to help pay for the Affordable Care Act.

Of course, any additional tax reduces your net income, and so we always try to avoid additional tax where possible. This tax rate of only 3.8% is pretty minimal by comparison to the rest of the income tax landscape, but it’s still extra tax. We should try to avoid or minimize this tax if at all possible.

What income is taxed by Net Investment Income Tax?

Net investment income tax is imposed on any net investment income over certain levels (covered below). For the purposes of this tax, net investment income includes (but it not necessarily limited to) the following:

• interest
• dividends
• capital gains
• rent income
• royalty income
• non-qualified annuity distributions
• “passive activity” income (reported as such on your tax return)
• income from businesses involved in trading of financial instruments or commodities
• net gains from the disposition of property

What income is not taxed by NIIT?

Since the above list indicates that it is not necessarily limited to those particular items of income, it’s important to know just what income is specifically not included as taxable under the Net Investment Income Tax. These items are excluded:

• wages
• unemployment compensation
• operating income from a nonpassive business
• Social Security benefits
• alimony (from a pre-2019 divorce settlement)
• tax-exempt interest
• self-employment income
• distributions from qualified plans (401(k), 403(b), etc.)
• distributions from qualified annuities
• distributions from qualified pensions
• distributions from IRAs
• gain on the sale of a personal residence (as excluded by the Section 121 exemption)

Who does the NIIT apply to?

As mentioned earlier, the NIIT only applies when overall income (as calculated by Modified Adjusted Gross Income) is above certain levels.

The Modified Adjusted Gross Income (MAGI) is calculated by first taking your Adjusted Gross Income (AGI, from line 8b of your Form 1040 or Form 1040SR) and adding any income attributable to a Controlled Foreign Corporation (CFC) or Passive Foreign Investment Company (PFIC), plus any foreign earned income that was excluded by Section 911 (usually reported on Form 2555). For most folks, the MAGI will be the same as the AGI. For more information on CFCs, PFICs and Section 911, see the instructions for Form 8960.

If the MAGI is greater than $200,000 (for single or head of household filers), then any Net Investment Income may be subject to the Net Investment Income Tax. For married filing jointly filers, the threshold is $250,000, and for married filing separately, the threshold is $125,000.

Calculating the Net Investment Income Tax

IRS Form 8960 is used to calculate the Net Investment Income Tax, if you are subject to it. That is, if your MAGI is above the threshold and you have Net Investment Income, you will need to fill out Form 8960 to calculate this additional tax.

Form 8960 simply adds up your total Investment Income, then allows certain deductions – investment interest, state & local income tax, and miscellaneous expenses – to come up with your Net Investment Income.

Next, your MAGI threshold (from above) is subtracted from the Net Investment Income. The resulting figure is compared to the total Net Investment Income – and whichever figure is lower is assessed the Net Investment Income Tax.

For example, if you had Net Investment Income of $50,000 and your MAGI is $225,000 (single filer), you will have $25,000 of Net Investment Income subject to the NIIT. (Subtract the single threshold of $200,000 from your MAGI of $225,000, resulting in $25,000, which is less than your total Net Investment Income of $50,000.)

For another example, let’s say you had Net Investment Income of $20,000 and your MAGI is $300,000 (married filing jointly). All of your $20,000 Net Investment Income is subject to the NIIT. (Subtract the MFJ threshold of $250,000 from your MAGI of $300,000, resulting in $50,000. The total of your Net Investment Income is less than $50,000, so the total Net Investment Income is subject to the Net Investment Income Tax.)

How to Avoid or Minimize NIIT

There are two items that you might be able to control in order to avoid or reduce your exposure to the Net Investment Income Tax:

1. Your Net Investment Income
2. Your Modified Adjusted Gross Income (MAGI)

Here are a few strategies you might employ to reduce your Net Investment Income:

• Tax-loss harvesting – sell your securities that have losses in the same year that you sell securities that have gains, partially (or completely) offsetting the capital gains you must realize on your tax return
• Use like-kind exchanges (Section 1031 exchanges) to defer gains on the same of property, especially real estate.
• If you’re charitably-inclined, donate your highly-appreciated securities (instead of cash) to a qualified charity so that the capital gain is not included in your income. You may also qualify for a deduction (if you itemize) for the basis of the donation.
• Hold high-appreciated securities and other assets to eventually be inherited by your heirs after your death. This eliminates the capital gains via the step-up provisions.

And here are a few ways you might reduce your MAGI:

• Maximize your deductible contributions to tax-deferred accounts such as 401(k) plans and SEP accounts.
• Invest in rental real estate, taking advantage of depreciation deductions to limit realized income.
• Invest in inherently tax-deferred items such as growth stocks, annuities, and insurance products. Income is not realized from these items until sold or withdrawn.
• Invest in municipal bonds, since the interest from these bonds is tax-exempt. This will reduce your MAGI but will increase your Net Investment Income.
• Convert funds from traditional IRAs to Roth IRAs. This strategy may result in Net Investment Income Tax in the year of the conversion(s), but future withdrawals of the Roth IRA funds will be eliminated from your MAGI, likely reducing or eliminating Net Investment Income Tax in the future.

As with all of these matters, it makes a lot of sense to consult an investment advisor and definitely your tax advisor before making any drastic moves with your investments.