What is the net investment income tax (NIIT)?
If you’ve never heard of the Net Investment Income Tax (NIIT), you’re not alone. This tax, which was introduced just over a decade ago, has affected a growing number of taxpayers each year. When it was first implemented, around 3.1 million taxpayers were subject to NIIT. Less than a decade later, that number more than doubled, impacting a much larger portion of high-income earners and investors.
NIIT is a 3.8% tax on certain investment income if your Modified Adjusted Gross Income (MAGI) exceeds a specific threshold. The tax applies to the lesser of either:
- Your net investment income (NII), or
- The amount by which your MAGI exceeds the threshold
Unlike other tax brackets that adjust for inflation, NIIT thresholds are fixed, meaning that more taxpayers become subject to the tax over time as wages and investment income rise.
What types of income are subject to NIIT?
Understanding what types of income trigger NIIT is crucial for taxpayers who want to plan ahead and manage their tax liability. The tax applies to those whose MAGI exceeds the following limits:
- Married filing jointly: $250,000
- Single or head of household: $200,000
- Married filing separately: $125,000
If your MAGI falls below these amounts, you are not subject to NIIT, regardless of how much investment income you have. However, if your income surpasses the threshold, NIIT applies to specific types of investment income, including:
- Interest and dividends
- Capital gains (including the sale of stocks, bonds, and real estate investments)
- Rental and royalty income
- Business trading income (passive earnings from investments in partnerships or other ventures)
- Non-qualified annuities
Not all income is subject to NIIT. The following types of earnings are exempt:
- Wages and unemployment compensation
- Social Security benefits
- Tax-exempt interest (such as municipal bond interest)
- Self-employment income
- Qualified retirement plan distributions (including 401(k), 403(b), and IRA withdrawals)
Strategies to reduce or avoid NIIT
While NIIT cannot always be avoided entirely, there are strategies that can help reduce its impact. The key is to lower your taxable investment income or keep your MAGI below the threshold. Here are some common approaches:
- Utilizing tax-advantaged accounts: Investing in tax-deferred or tax-free accounts, such as Roth IRAs, 401(k)s, and Health Savings Accounts (HSAs), can help shield your investments from NIIT.
- Harvesting losses: Selling investments at a loss to offset capital gains can help reduce your net investment income.
- Managing asset sales: Spreading the sale of an asset over multiple years (installment sales) may help keep your income below the threshold.
- Deducting investment-related expenses: Certain expenses, such as investment advisory fees, brokerage fees, and tax preparation costs, can reduce taxable investment income.
NIIT in action: A tax calculation example
To illustrate how NIIT works, consider the following example: A single taxpayer earns $175,000 in wages and $80,000 in dividends, bringing their MAGI to $255,000. Since the NIIT threshold for single filers is $200,000, the taxpayer is subject to the tax. The tax applies to the lesser of:
- The amount exceeding the threshold: $255,000 – $200,000 = $55,000
- Their total investment income: $80,000
Since $55,000 is the lower amount, NIIT applies to that portion. The tax calculation is: 3.8% of $55,000 = $2,090 in NIIT owed.
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Does NIIT apply to home sales and medicare taxes?
One common question is whether NIIT applies to the sale of a primary residence. Generally, it does not, as long as the gain from the sale is within the exclusion limits ($250,000 for single filers and $500,000 for joint filers). However, if the profit exceeds those limits and pushes your MAGI above the threshold, the excess amount may be subject to NIIT.
Additionally, NIIT is sometimes confused with the 3.8% Medicare surtax. While both taxes were introduced under the Affordable Care Act, they serve different purposes. NIIT applies only to investment income, while the 0.9% Medicare tax applies to earned income above certain thresholds. It’s important to note that even though NIIT is sometimes called a “Medicare tax,” the revenue it generates does not go toward Medicare funding.
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Final thoughts
With tax laws constantly evolving, it’s essential to stay informed about how NIIT may affect your finances. Taxpayers earning significant investment income should consider working with a tax professional to minimize their tax liability. For more information, the IRS provides a list of NIIT FAQs, and their online withholding estimator can help you calculate potential tax obligations, including NIIT.
