A lot of the questions I receive from clients are triggered by newspaper articles or stories on the business news channel that they come across. That was the case this week when a client asked about a tax mentioned in the Wall Street Journal – the Net Investment Income Tax. Let’s take a look
What is the Net Investment Income Tax?
This tax (called NIIT for short) was enacted in 2013 to help fund the Affordable Care Act. It’s a 3.8% tax on a taxpayer’s net investment income (which includes items like interest, dividends and capital gains).
The tax only applies in certain cases, determined by income level (those with adjusted gross income, or AGI, above $200,000 for most single filers or $250,000 for most married couples).
Why are people paying attention to this now?
As noted above, this tax is 10 years old. However, it’s suddenly getting a lot of attention. Why? When the tax was put in place, the income thresholds (listed above) were NOT scheduled to increase for inflation. As a result, as incomes, interest rates, and investment returns have risen in recent years, these cutoffs have stayed the same, resulting in more people exceeding them and having to pay the resulting NIIT.
According the the Wall Street Journal article my client read, the annual proceeds from NIIT have tripled from 2013 and the number of tax payers subject to it has doubled. (Article also notes that had cut-offs been indexed to inflation, they would now be close to $264,000 single and $330,000 married)
Do wages and distributions impact this tax?
Yes and No. Other sources of income (like wages or taxable retirement distributions) do come into play as they will increase your adjusted gross income (AGI) – which is subject to those thresholds noted above. So while those sources of income themselves are not subject to the NIIT, the income “stacks” and may push the net investment income above the thresholds, thereby triggering the NIIT.
How does the calculation work?
You will pay the 3.8% NIIT on the investment income that exceeds the noted thresholds. The net investment income is viewed as “stacking” atop other sources of income.
As an example, a married couple has wages and IRA distributions of $245,000. They also have $15,000 of interest income. Their total income ($260,000) exceeds the $250,000 threshold, and as a result, they will owe 3.8% on the investment income above that threshold (ie: $10,000, $260,000 – $250,000) or $380
Is there anything you can do?
Yes. There are a few things you can do if you wish to mitigate (or even avoid) this added tax.
Adjust income – Again the NIIT applies only to income above set thresholds. You can reduce your adjusted gross income (to stay below those levels) by making retirement or health savings account contributions. Keep in mind that deductions (like charitable donations and medical expenses) won’t help in this case as they don’t lower adjusted gross income (they instead reduce taxable income).
Donate directly from IRAs – If you are at an age where you have to take distributions from your IRAs, that income may push you above the threshold. You may wish to consider donating to charity directly from your IRA (known as a qualified charitable distribution). This allows the distribution to go directly to charity and as a result, it would not be included in your adjusted gross income
Adjust investments – Certain investments (like Muni bonds) are not subject to the tax at all. Further, some investments generate more income (subject to this tax) than others. If this tax is a major consideration for you, using tax-deferred accounts for income generating investments may be wise
Harvest losses – If you have securities that have depreciated in value, you can sell them to take the loss (which will offset any gains and income – and perhaps reduce your tax)
As with all taxes, it’s important to remember you are paying them due to a certain level of success and earnings. So, try not to overreact too much to the NIIT. But hopefully this has helped explain a potentially new line item on your next return!
Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment or tax advice and are not responsible for any actions taken based on this article. Consult your own advisors to determine how this information may impact your specific situation
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