When tax preparers receive the information they need, they calculate your taxes and tell you how much you owe. Unfortunately, there are often unforeseen surprises when it comes time to write that check. One of these surprises that can often be avoided through proper tax planning is Net Investment Income Tax (NIIT).

What Is the Net Investment Income Tax?

The net investment income tax is a tax related to the net investment income of certain individuals, estates and trusts. More specifically, this applies to the lesser of your net investment income, or the amount by which your modified adjusted gross income (MAGI) surpasses the filing status-based thresholds the IRS imposes. The NIIT is currently set at 3.8%.

Who is Subject to the Net Investment Income Tax?

Only U.S. citizens and resident aliens with net investment income that exceeds the MAGI thresholds in the table below need to pay the NIIT. Non-resident aliens are not subject to this tax. The only exception is if they elect to be treated as a resident so they can file jointly with their U.S. citizen or resident spouse.

Figure 1: Net Investment Income Tax (NIIT) Thresholds

Your Filing Status Threshold Amount
Single $200,000
Married Filing Jointly $250,000
Married Filing Separately $125,000
Head of Household (with Qualifying Person) $200,000
Qualifying Widow(er) with Dependent Child $250,000

Estates and trusts may also need to pay the NIIT. This pertains to estates and trusts that have both undistributed net investment income and adjusted gross income past the dollar amount at which the highest estate/trust tax bracket begins for the current tax year. The IRS stipulates that there are a few types of trusts not subject to the NIIT, including:

  • Trusts that are exempt from income taxes
  • Grantor trusts
  • Trusts not technically classified as “trusts” for federal income tax purposes
  • Perpetual care trusts
  • Electing Alaska Native Settlement Trusts

What Is Net Investment Income?

In order to turn a profit, investors aim to buy investments at a lower price than what they’ll eventually sell them for. But there are many different kinds of investments, and not all of them are included as net investment income.

Income that is included as net investment income:

  • Interest
  • Capital gains
  • Dividends
  • Income from passive investment activities
  • Non-qualified annuity distributions
  • Rental and royalty income

Income that is excluded from net investment income:

  • Wages
  • Unemployment payments
  • Self-employment income
  • Social Security benefits
  • Distributions from some qualified retirement plans
  • Alimony
  • Tax-exempt interest
  • Operating income from nonpassive businesses
  • Excluded capital gains earned from the sale of your primary residence
  • Alaska Permanent Fund Dividends

How Is NIIT Calculated?

Your MAGI determines if you owe the net investment income tax. To calculate your MAGI, take your adjusted gross income (AGI) and add back in a few deductions, like IRA contributions, passive loss or income, taxable Social Security payments, student loan interest and more. You can find your AGI on Form 1040, Line 8b. If your MAGI is higher than the statutory threshold for your filing status, then you must pay the net investment income tax.

Next, you’ll need to figure out your net investment income based on the included earnings listed above. Once you know your gross investment income, subtracting eligible deductions will provide your net investment income. Some common investment deductions are brokerage fees, investment advisory fees, tax preparation charges, local and state income taxes, fiduciary expenses, investment interest expenses, and any costs involved with rental and royalty income.

As stated earlier, you pay the NIIT based on the lesser of your net investment income or the amount by which your MAGI surpasses the filing status-based thresholds imposed by the IRS. In simpler terms, the dollar amount that’s subject to this 3.8% tax will vary as follows:

  • If your net investment income is lower than the amount by which you exceeded the statutory threshold, the tax applies to your net investment income.
  • If your net investment income is higher than the amount by which you exceeded the statutory threshold, the tax applies to that exceeding value.

How Do You Plan for NIIT?

Luckily, there are opportunities to strategize in advance so you’re not surprised by NIIT:

Timing Capital Gains Recognition

Since taxable capital gains result from transactions, it’s possible to manage the year in which capital gains are realized. This is typically not an option for people who have consistent earnings above the NIIT threshold. But for people who may be considering retirement or business owners and others that may have their AGI fluctuate from year to year, this can be a good option by realizing more of the capital gains in the years with reduced income.

Asset Allocation

Another strategy is to allocate assets that may have capital gains in tax-deferred or tax-advantaged accounts such as an IRA or Roth IRA.

Explore Other Investment Vehicles

Higher income, higher net worth individuals that hold securities with low cost basis facing more substantial capital gains may have other options such as an Exchange Fund or Economic Opportunity Zone. These investment vehicles allow individuals to “swap” their existing position in exchange for a basket of securities. These funds don’t allow individuals to avoid capital gains but instead allow for diversification and may offer additional tax benefits.

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.

Get Help to Sort Through the Complications

It’s critical to consult a financial advisor to gain a clear understanding of the impact of transactions before you execute them. At Wealth Enhancement Group, we integrate financial and tax planning with investment management to assist clients with improving and simplifying their financial life, including helping clients navigate the complexity of NIIT and other hidden taxes. 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.

 

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

Chris Schiffer

Chris Schiffer

Senior Vice President, Financial Advisor-CRP

MBA, CFP® AIF®, CPA, CPFA, Life & Health Insurance License Chris has more than 30 years of experience in the financial services industry in the areas of accounting and financial planning. He is well-versed in the financial challenges faced by most individuals. Chris has also authored articles on financial planning, divorce and the financial markets. In addition, for those going through divorce, has appeared as a subject matter expert on a number of media outlets, as well as...Read More