What is net investment income tax and who pays it?

If your investments have recently made money, you may owe something called net investment income tax (NIIT) on your profits. Although many investors are not likely to be affected by this bill, it is important to know whether or not you are subject to the NIIT payment to avoid any surprises when filing your taxes.

What is net tax on investment income?

NIIT is a net investment income tax. Those subject to the tax will pay 3.8% on the lesser of the following: their net investment income Where the amount by which their Modified Adjusted Gross Income (MAGI) extends beyond their specific income threshold.

Net investment income generally includes the following:

  • interest
  • dividends
  • capital gains
  • income from rental properties
  • royalty fee
  • non-qualified annuities (the taxable part of investments)
  • passive investment income
  • business income from financial trading (this is earned income if it comes from your job)

Qualified annuities can be part of a retirement plan or an IRA, and therefore subject to different tax laws. Non-qualified annuities, such as those that are personally owned (as one would personally own a brokerage account, for example) fall under net investment income.

These are broader examples of what falls under net investment income – estates and trusts, for example, may also be subject to tax depending on certain rules and how they are titled. The IRS details exactly what is considered net investment income and what is not. It is important to note that “net” means once the losses are already deducted from the investment. It also doesn’t include your investment principal, or say, the original value of a house or estate.

There are several other types of income that the IRS states do not count for NIIT:

  • wages
  • Unemployment benefits
  • alimony payments
  • most income from self-employment
  • Social security benefits
  • qualified plan withdrawals (401(k), IRA, etc.)
  • money received from traditional defined pensions or pension plan annuities
  • life insurance product
  • proceeds of state/local government or other tax-exempt organizations
  • investment income from an active business

Who is subject to NIIT payment?

Not everyone will have to pay the NIIT, and only those above certain income thresholds will be subject to it. The IRS statutory income thresholds are as follows:

  • Joint Joint Deposit – $250,000
  • Groom filing separately – $125,000
  • Single or head of household — $200,000
  • Eligible widow(er) with one child — $250,000

Those who exceed the income thresholds based on their filing status should consider whether their net investment income Where the amount by which their MAGI exceeds it is greater. The lower of the two numbers is the one that will be subject to the additional 3.8% tax.

How the NIIT is calculated

Here is an example of calculating the NIIT.

Kelly and John are married, file jointly, and their MAGI is $500,000. This means that they exceed their filing status threshold of $250,000 and will certainly be subject to NIIT if they have net investment income. After all the calculations are rounded for the year, their net investment income comes to $100,000. This means that they will be subject to the NIIT of 3.8% on the $100,000, as this is the lesser of the two figures. Kelly and John would then have to pay $3,800 in NIIT tax, or $100,000 x 0.038 = $3,800.

If their net investment income had been, say, $300,000, then Kelly and John would pay 3.8% 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 are concerned about being subject to the additional tax, there are several ways to offset the net income. The best thing to do is talk to a professional chartered accountant who can help you make sure that anything you’re offsetting is IRS-compliant.

But for reference, there are useful ways for individuals to avoid being subject to additional tax on their net investment income.

Overall, the goal is to reduce your taxable income so that you can fall below the income threshold. Popular ways to do this are to contribute to tax-efficient plans such as 401(k), 403(b), traditional IRA, or SEP IRA.

This can also be done by offsetting (non-qualifying) investment losses with some of your investment gains. Individuals achieve this by using their losing investments to reduce the taxable amount of their winning investments, in what is known as tax loss harvesting.

Another strategy is to increase the amount you claim for certain investment expenses, which then reduces net investment income. These can include expenses you deduct for upkeep or maintenance of a rental property, negotiation fees, and even state taxes. Property taxes on investment properties could even serve as a way to offset net investment income, but again, it’s important to be careful that it’s properly titled and legal.

If these approaches still do not reduce your income enough to avoid the additional tax, then you will need to explore other deductions, ideally with a CPA.

Learn more: