What Is The The Net Investment Income Tax (NIIT)? – Low Cost Advisor
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Created as part of the Health Care and Education Reconciliation Act to fund healthcare reform in 2010, the net investment income tax (NIIT) is a 3.8% surtax that typically applies only to high earners with considerable investment income.
Who Pays the Net Investment Income Tax?
The net investment income tax applies to taxpayers who have a significant amount of investment income, typically high-net-worth families and individuals with considerable assets.
Net investment income is money you earn from your investments. It might include dividends, interest payments and capital gains you realize when you sell a security, like a stock, for more than you originally paid for it. In addition, royalty payments, some types of annuity payments and rental income from real estate investments are also considered investment income.
Net investment income tax thresholds are based on tax filing status and income (as defined by modified adjusted gross income).
NIIT can be of particular concern to retirees who pay for their living expenses from investment income. Pension payments and withdrawals from tax-deferred retirement accounts are both taken into account in calculating net investment income. Withdrawals from Roth accounts, on the other hand, are not.
How to Calculate Net Investment Income Tax
The net investment income tax is a 3.8% surtax that is paid in addition to regular income taxes. But not everyone who makes income from their investments is impacted. It only applies to incomes that are above the thresholds highlighted above.
In practical terms, this means that in addition to net investment income, you’ll also need your modified adjusted gross income (MAGI) to compute your NIIT. Here’s how you calculate both.
How to Calculate Net Investment Income
Net investment income is calculated by adding up all of the income you earned from investments in the past tax year and subtracting any related expenses.
This includes profits you realized when you sold investments, dividend and interest payments you received and income from rental properties, among other forms of investment income defined by the IRS. Related expenses might include commissions and tax preparation fees.
How to Calculate Modified Adjusted Gross Income (MAGI)
MAGI is a household’s adjusted gross income with tax-exempt interest payments and certain deductions, like student loan interest payments and individual retirement account (IRA) contributions, included again.
You can find your adjusted gross income on line 11 of the 2020 Form 1040. You’ll then need to add back deductions such as student loan interest payments, tuition expenses, IRA contributions, taxable Social Security payments, the deduction for self-employment taxes and rental losses. Relevant deductions will be listed on Schedules 1, 2 and 3 to Form 1040.
How to Calculate Net Investment Income Tax
Now we have the components, let’s calculate NIIT. If your MAGI exceeds the thresholds listed above, you’ll probably incur the net investment income tax and will need to calculate NIIT on Form 8960.
Calculating NIIT is not just as simple as multiplying your net investment earnings by 3.8%. The IRS gives you a pass. You are charged 3.8% of the lesser of net investment income or the amount by which the MAGI exceeds the income thresholds you must pass to incur NIITs.
For example, if you were a single filer who earned $250,000, and $25,000 of that was net investment income, your NIIT would be based on only the income you earned from your investments. That’s because $25,000 is less than $50,000—the difference between the $200,000 cutoff and $250,000. Your NIIT would then be $950.
If, on the other hand, you’d earned $75,000 of net investment income but had the same MAGI, your NIIT would be based on the $50,000 you earned over the cutoff. In that case, your NIIT would be $1,900.
How to Pay NIIT
If you discover you owe net investment income tax, you must report it on Form 1040. Estates and trusts that owe the tax use Form 1041 for reporting purposes. If you need to send the IRS money to balance your taxes, you will do so the same way you pay your other income taxes.
If you need help calculating NIIT obligations or determining how best to pay it, check with a tax professional.
Strategies to Manage Net Investment Income Tax
Just because you are a high earner who earns significant investment income doesn’t mean you’re destined to pay huge NIIT amounts. You can manage your net investment income tax liability using strategies to reduce both the amount of net investment income reported and modified adjusted gross income. However, Chris Schiffer of the Wealth Enhancement Group in Basking Ridge, N.J., cautions that “the tax tail shouldn’t wag the investment dog.”
If you’re the one in charge of the leash, though, here’s what you can do.
Time Your Capital Gains
If you can, pay particular attention to the timing of capital gains recognition, Schiffer suggests. You may be able to time the sale of securities that have seen large gains with the simultaneous sale of those that have seen significant losses. This is a process called tax-loss harvesting that can help you decrease the net income you see. If your income fluctuates significantly year to year, you may also be able to time the sale of your securities to years when your MAGI is below the NIIT threshold, Schiffer notes.
Take Advantage of Charitable Contributions
If you can’t postpone realizing your gains you aren’t out of options, though. You may be able to reduce net investment income through charitable contributions. If you’re already planning to make charitable donations, see if you can swap your cash payments for a donation of appreciated securities instead. This way, you won’t be obligated to report a gain on your tax return and you’ll still be able to enjoy the tax deduction that comes from the charitable contribution.
In addition, you might consider a charitable remainder trust (CRT) to reduce NIIT liability. “A CRT is an irrevocable, tax-exempt trust in which the grantor places assets to provide income during a specific period of time. CRTs are exempt from Section 1411 [the section of the tax code that applies to the NIIT], which means that gains sold by the CRT won’t be subject to the net investment income tax,” Schiffer says.
Adjust Your MAGI
If none of those methods work for you, turn instead to your modified adjusted gross income. If you’re reliant on fixed income investments, consider municipal bonds instead of other bond types. These instruments are exempt from federal tax and also generally exempt from state income tax if the bonds are issued in the state where the taxpayer resides.
Other investments that can help reduce MAGI include growth stocks, which typically don’t pay dividends and won’t affect your MAGI until you sell them and realize gains. Instruments like whole life policies that accumulate cash value and tax-deferred annuities don’t generate taxable income until withdrawal. Importantly, aim to maximize contributions to tax-advantaged retirement vehicles like 401(k) and SEP accounts. Unlike IRA contributions, contributions to these accounts do decrease your MAGI.
These, of course, are only a few of the strategies that can help reduce net investment income tax liability. For taxpayers with high incomes and significant invested assets, managing tax liability can be a complicated business best served by the help of a tax professional.