This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma Tax®.
Who wouldn’t love to make a killing in the stock market or other types of investments?
Investing can help you grow wealth, but if you make a killing, you’re likely going to be affected by the Net Investment Income Tax. The NIIT took effect January 2013 as a part of the Health Care and Education Reconciliation Act of 2010.
“Its purpose was to generate approximately half the revenue needed for the Affordable Care Act,” says Megan Gorman, founder and managing partner at Chequers Financial Management in San Francisco.
If you are subject to the NIIT, you could owe a 3.8 percent NIIT tax on your net investment income or on the amount by which your modified adjusted gross income exceeds the statutory threshold amount for your filing status.
Confused? You’re not alone.
The net investment income tax is a complex tax law that can surprise unwitting taxpayers who have a one-time increase in investment income, such as from selling an investment property or selling inherited stock.
We’ll cover the basics of what the net investment income tax is, how you could be affected and steps you can take to avoid the tax.
- What is net investment income?
- Who pays the net investment income tax?
- How can I avoid the NIIT?
- How do I report and pay NIIT?
What is net investment income?
For the purposes of the NIIT, investment income includes the following:
- Distributions from annuities
- Capital gains
- Income from passive activities
Excluded from net investment income:
- Income from salaries and wages
- Distributions from certain qualified retirement plans
- Self-employment income
- Operating income from a nonpassive business
- Excluded capital gains from the sale of your principal residence
- Tax-exempt interest
- Social Security benefits
- Unemployment income
- Alaska Permanent Fund DividendsHowever, as the name implies, the tax is assessed on net investment income rather than gross investment income. So the amount of income subject to NIIT is reduced by any deductions related to investments. That may include investment interest expense, investment advisory and brokerage fees, expenses allocable to a rental property or royalty income, state and local income taxes, and even fees paid to prepare your tax return.
Who pays the net investment income tax?
The NIIT applies only when a taxpayer’s modified adjusted gross income (MAGI) exceeds a threshold amount. The thresholds for each filing status are as follows:
- Single: $200,000
- Married filing jointly: $250,000
- Married filing separately: $125,000
- Head of household: $200,000
- Qualifying widow(er) with dependent child: $250,000
These thresholds aren’t indexed for inflation, so they remain the same year after year.
It also helps to understand how modified adjusted gross income is calculated. While you can find your adjusted gross income on the last line of the first page of your Form 1040, U.S. Individual Income Tax Return, MAGI does not appear on your return.
MAGI is your AGI plus any untaxed foreign income and/or foreign housing exclusion, rental losses with some exceptions, nontaxable Social Security benefits, any deductions for student loan interest or IRA contributions, employer-provided adoption benefits, and qualified tax-exempt interest. For many people, MAGI is very close or identical to their AGI.
In theory, NIIT impacts only high earners who make up roughly 2 percent of the population. However, it can affect any taxpayer who has a one-time increase in income. For instance, selling an investment property, shares of stock or a business, or converting a traditional to a Roth IRA, can increase the taxpayer’s MAGI over the threshold and trigger the NIIT.
How can I avoid the NIIT?
If you’re worried you may be subject to NIIT and want to avoid it (or minimize the impact), there are tax-planning strategies that might help you keep your MAGI below the applicable threshold.
- Roth IRA conversion: Distributions from a Roth IRA are not included in net investment income, but converting a traditional IRA to a Roth IRA can increase your MAGI in the year of the conversion, making your other investment income subject to NIIT. Consider doing any conversion over a number of years in order to keep your annual MAGI below the threshold that triggers NIIT.
- Installment sales: If you sell a business or investment property, the gain from the sale is subject to NIIT and can push your MAGI over the applicable threshold. Consider an installment sale, where the proceeds and gain are spread out over multiple years to avoid or delay triggering NIIT.
- Reduce MAGI: Lowering your MAGI with above-the-line deductions can help you avoid NIIT. Consider contributing to a health savings account, self-employed retirement plan or traditional IRA to lower your AGI.
- Donate appreciated assets: You may like to donate to charity. Instead of selling an asset, which would force you to recognize the gain, and then writing a check to the charity, Gorman recommends donating assets that have appreciated directly to charity. “You won’t have to recognize the gain, and thus not pay NIIT,” she says. Make sure these donations are to IRS-approved charities.
- Sell your underachievers: If you have securities that are not performing as you would like, you could sell them to generate a loss. That loss can offset your net capital gains, so long as the securities are classified as net investment income. Make sure you’re also using any capital-loss carryovers from prior years. This strategy is known as tax-loss harvesting.
How do I report and pay NIIT?
NIIT is calculated and reported on Form 8960 which is filed along with your Form 1040 individual tax return. Credit Karma Tax®, a free online tax preparation filing service, supports Form 8960, and can help you identify credits and deductions that you qualify for and that could help lower your tax bill.
Here’s an example to help illustrate how NIIT is calculated. Jim and Susan are a married couple earning a combined $230,000 in wages. They also have an additional $30,000 in net investment income from interest, dividends and capital gains from stock sales.
Their MAGI exceeds the threshold of $250,000 for a married couple filing jointly by $10,000 (230,000 + 30,000 – 250,000 = 10,000), and their net investment income is $30,000.
NIIT is based on the lesser of $10,000 (the amount by which their MAGI exceeds the $250,000 threshold) or $30,000 (their net investment income). Jim and Susan would owe NIIT of $380 ($10,000 x 3.8 percent).
There have been a few proposals to repeal the Affordable Care Act — repealing the ACA would also eliminate the Net Investment Income Tax.
“Despite tax reform eliminating the tax penalty for not having insurance starting in 2019, the NIIT has not been impacted,” Gorman says. “So it’s here to stay — which means it will continue to irritate investors.”
However, the new tax policy did affect deductions and exclusions that may impact your NIIT liability. For example, the net interest deduction is now capped at 30 percent of pre-interest earnings, whereas it was unlimited prior to reform. The deduction for state and local taxes is also limited now, to $10,000, and the new law caps exempt mortgage interest payments as well.
The NIIT and recent changes to the tax code are complex; knowing exactly how they will affect your return depends on your particular facts and circumstances. For that reason, Gorman recommends working with a tax professional to help you plan for 2018 and beyond. With proper planning, you may be able to defer, reduce or even avoid the NIIT completely.
Christina Taylor is senior manager of tax operations for Credit Karma Tax®. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.