If your investments make money, you may owe net investment income tax (NIIT) on your gains. While it is unlikely that many investors will be affected by this bill, it is important to know whether or not you are covered by the NIIT to avoid surprises when it comes time to file your taxes.
What is the net investment tax?
NIIT is a tax on net investment income. Those subject to the tax pay 3.8 percent on the tax fewer of the following: their net investment income or the amount by which their adjusted gross income (MAGI) exceeds their specific income threshold.
Net investment income generally includes the following:
- interest
- dividends
- capital gains
- income from rental properties
- royalties
- non-qualified annuities (the taxable portion of the investments)
- passive investment income
- business income from financial trading (this is income from your work)
Qualified annuities may be part of a retirement plan or IRA and thus subject to different tax laws. Non-qualified annuities, such as annuities that are personally owned (for example, as someone would personally own an investment account), fall under the umbrella of net investment income.
These are the broader examples of what falls under net investment income – but estates and trusts, for example, can also be subject to tax, depending on certain rules and their title. The tax authorities shows exactly what qualifies as net investment income. It is important to note that ‘net income’ means losses have been deducted from the investment.
There are several other types of income that the IRS states do not count toward the NIIT:
- wage
- unemployment benefits
- alimony payments
- most income as a self-employed person
- Social Security Benefits
- qualified withdrawals from plans (401(k), IRA, etc.)
- money received from traditional defined benefit pensions or annuities from pension schemes
- proceeds from life insurance policies
- proceeds from state/local government or other tax-exempt organizations
- active business investment income
Who has to pay NIIT?
Not everyone has to pay the NIIT, and only those above certain income thresholds will be subject to it. The IRS statutory income thresholds are as follows:
- Married Filing Jointly – $250,000
- Married filing separately – $125,000
- Single or head of household – $200,000
- Eligible widow(er) — $250,000
Those who exceed the income thresholds based on their filing status must determine whether their net investment income or the amount by which their MAGI exceeds the threshold is greater. The lower number of the two is the number to which the additional tax of 3.8 percent will apply. The income limits are not indexed for inflation.
How NIIT is calculated
Here is an example of how you can calculate NIIT.
Kelly and John are married and filing jointly, and their MAGI is $500,000, which exceeds the filing status threshold by $250,000. They will certainly be subject to NIIT if they have net investment income. After all gains and losses for the year are calculated, their net investment income comes to $100,000. So they will be subject to the NIIT of 3.8 percent on the $100,000, because it is the lower of the two numbers. Kelly and John would have to pay $3,800 to NIIT, or $100,000 x 0.038 = $3,800.
If their net investment income had been $300,000, Kelly and John would pay 3.8 percent on the $250,000 by which their MAGI exceeds the income thresholds. Here, Kelly and John would pay $9,500 in NIIT tax, or $250,000 x 0.038 = $9,500.
How to avoid NIIT
If you’re concerned that you may have to pay extra taxes, you have several ways to offset your net income. The best thing you can do is talk to a licensed accountant who can help you ensure that anything you compensate is IRS-friendly.
Overall, the goal is to reduce your taxable income so you can fall below the income limit. Popular ways to do this include contributing to tax-advantaged accounts such as a 401(k), 403(b), traditional IRA, or SEP IRA. Contributions to these accounts before taxes reduce your overall taxable income.
You can also reduce your income by offsetting (non-qualified) investment losses with a portion of your investment gains. You can use your losing investments to reduce the taxable amount of your winning investments, in a process known as tax-loss harvesting.
Another strategy is to increase the amount you claim for certain investment expenses, which will reduce your net investment income. These costs can include deductions for rental property maintenance or upkeep, trade fees, and even state taxes. Real estate taxes on investment properties can even serve as a way to offset net investment income, but again it is important to ensure that the tax is properly titled and legal.
If these approaches still don’t reduce your income significantly enough to avoid the additional tax, you should explore other deductions, ideally with a CPA. Even if you can’t reduce your taxable income this year, you may be able to manage your finances in the coming year.
