Tax year 2013 saw a number of changes, including an increase in the top marginal rate to 39.6% and an increase in the Social Security tax, returning us to the 2010 rate. Tax year 2013 also saw the implementation of a new tax that higher-income individuals may be subject to: the Net Investment Income Tax (NIIT) which was included in the Affordable Care Act of 2010.

The NIIT is a flat, 3.8% surtax. The 3.8% rate is assessed if you exceed certain modified adjusted gross income (MAGI) thresholds which depend on your filing status. Generally speaking, your MAGI is the sum of your adjusted gross income and the amount of the net foreign income exclusion. Currently, the thresholds for the NIIT are:

Filing Status Threshold Amount
Single $200,000
Married filing separately $125,000
Married filing jointly $250,000
Head of household (with qualifying person) $200,000
Qualifying widow(er) with dependent child $250,000

 

One thing to remember is that these thresholds are not indexed to inflation.

The NIIT is assessed on either your MAGI that exceeds the threshold or your Net Investment Income for the year, assuming your MAGI exceeds the threshold. The NIIT will be assessed on whichever amount is lower.

Here’s an example: Walt, a single filer, had a MAGI of $270,000 which includes $30,000 of investment income. His MAGI is $70,000 over the threshold, while he only had $30,000 in investment income. Walt will pay the NIIT on his $30,000 in Net Investment Income, because that amount is lower than his MAGI that exceeds the $200,000 threshold ($70,000), for a tax bill of $1,140.

What is considered “Net Investment Income?”

What the IRS defines as Net Investment Income is a key to understanding and preparing for this tax. According to the IRS, investment income includes, but is not limited to:

  • Interest
  • Dividends and capital gains
  • Rental and royalty income
  • Non-qualified annuities
  • Income from businesses involved in trading of financial instruments or commodities
  • Businesses that are passive activities to the taxpayer

Just as it’s important to know what the IRS defines as investment income, it’s also important to recognize common sources of income that are not factored into a person’s Net Investment Income:

  • Wages and self-employment income
  • Unemployment compensation
  • Social Security benefits
  • Tax-exempt interest (municipal bonds, for example)

How to limit the tax hit

Here are three ways that may allow you to reduce your exposure to the NIIT:

  1. Time your income. If you are planning on receiving a large capital gain during the year, see if you can have those earnings spread out over several years rather than in one lump sum. For example, let’s say a couple filing jointly makes $100,000 annually and owns $200,000 in stocks they are looking to sell. Rather than selling all $200,000 at once (which would expose them to an additional tax bill of $1,900 from the NIIT), the couple could sell half this year and half next year to avoid going over the threshold.
  2. Consider a Roth IRA conversion. Income distributions from a Roth IRA are not included in your Net Investment Income (assuming that the distributions are qualified). Another great thing about a Roth IRA is that, unlike traditional IRAs and 401ks, you don’t have to take required minimum distributions when you turn 70 ½ (Roth 401k plans do require you take required minimum distributions at 70½). While you will have to pay taxes on the amount you rollover from a traditional to account to the Roth IRA, you will not have to take those required minimum distributions that will affect both your MAGI and your Net Investment Income.
    Keep in mind that while the conversion won’t be considered as investment income, it will be considered in your MAGI. This means if you have a large account you are converting, you could go over the threshold and trigger the NIIT during the conversion year. A partial conversion may help you move money into a Roth IRA without exceeding the threshold. Working with a financial advisor can help you understand the implications of a Roth conversion and whether it’s right for you.
  3. Contribute to a Charitable Remainder Trust (CRT). A CRT is an irrevocable, tax-exempt trust in which you place assets to provide income for you during a specific period of time. CRTs are exempt from Section 1411 (the section of the tax code that details the NIIT) which means gains sold by the CRT won’t be subject to the NIIT. A financial advisor can help you understand how to set up a CRT and whether it’s right for you.

Tax laws are complex, and the NIIT is no exception. Working with a tax professional can help you better understand how the NIIT will affect your unique situation and how you can best prepare for it.

Ryan McKeown

Ryan McKeown

Senior Vice President, Financial Advisor

CFP®, CPA, Series 7 Securities Registration,1 Series 66 Advisory Registration,† Insurance License As a Certified Public Accountant and CERTIFIED FINANCIAL PLANNER™ professional, Ryan brings an extensive tax and retirement income planning background to Wealth Enhancement Group. He helps lead the Tax Strategies group of our Roundtable team of specialists and is a frequent guest on our weekly “Your Money” radio program....Read More