Net Investment Income Tax- A Hit to Your Investments
If you invest in stocks, bonds, mutual funds, ETFs, cryptocurrency, real estate, or other assets that produce income and gains, then you definitely know how tough it can be to achieve a successful result. This is especially true in 2022—many analysts have described the recent downtown in the crypto markets as a “crypto crash” and we have been teetering on the brink of a bear market with securities. And who knows, by the time you read this we may be in one!
Well, let’s assume you did well in buying and selling at optimal times or producing interest, dividends, or rental income as a result of your investment choices. Let’s also assume that these investments did not take place within a tax-sheltered account such as a 401k or IRA. You now have additional taxable income.
Most investors are aware that the IRS taxes this additional income at your marginal tax rate (your federal tax bracket) unless the preferable capital gains rates of 0%, 15%, or 20% apply (such as in situations in which you have long-term capital gains or qualified dividends). If you live in a state that also taxes income, you can also tack on the state’s marginal tax rate (your state tax bracket) or the flat tax rate that applies if your state does not use graduated tax rates (such as my state—North Carolina). But did you know you may also have to pay a third tax called Net Investment Income Tax (NIIT) on your investment income?
What is Net Investment Income Tax (NIIT)?
NIIT is an additional tax on investment income assessed on a taxpayer’s individual, estate, or trust tax return in circumstances where the taxpayer’s income is above certain thresholds. In layman’s terms, the tax aims to target higher income and higher wealth taxpayers. NIIT went into effect on January 1, 2013, as part of the Health Care and Education Reconciliation Act to provide health care funding for Americans who have insurance under the Affordable Care Act (Obamacare). Although the Shared Responsibility Penalty (individual mandate penalty) that applied to taxpayers who did not maintain health insurance has been reduced to $0 beginning in 2019, the NIIT remains in place and is assessed on many of my clients’ tax returns each year.
How Much Tax Are You Paying on Your Investment Income?
If you are subject to NIIT, let’s assume that you are in the highest tax bracket, which is currently 37% for federal tax. Let’s further assume that you live in California, and you are subject to the highest tax bracket, which is potentially 13.3% if your income for that year exceeds $1 million (and this can happen to an ordinary married couple, both working in Silicon Valley, who sold some appreciated real estate that is not subject to the principal residence exclusion). Then let’s assume that you are subject to the NIIT of 3.8%. You are now paying taxes of 54.1% on your investment income, meaning that the government is getting most of the money that you have earned from your investments! And this is not anything new under the Biden Administration- these rates have been in place for several years. But regardless of how long the rates have been in place, this is a huge tax hit for which higher-income taxpayers should definitely implement planning strategies.
What is Considered Investment Income for NIIT Purposes?
Investment income generally includes interest, dividends, capital gains, rental and royalty income, and income from passive activity businesses (i.e. K-1 income that is considered passive because you do not actively participate in the business). However, you are potentially allowed to offset certain state taxes and investment expenses (from Schedule A that are taken as an itemized deduction) against your investment income before NIIT is calculated, so be sure to always provide your CPA with details on your investment advisory and brokerage fees, rental and royalty expenses, and other investment-related expenses that can potentially offset your net investment income if you are a taxpayer who itemizes deductions.
Who Has to Pay NIIT?
Single and Head of Household filers start paying NIIT when their modified adjusted gross income (MAGI) is over $200,000 and Married Filing Jointly and Qualifying Widow(er) filers start paying net investment tax when their MAGI is over $250,000 (bonus points for you if you noticed the marriage penalty). The threshold for Married Filing Separately is a MAGI over $125,000. These amounts are not adjusted for inflation, which means that NIIT tends to hit more taxpayers with each passing year since wages tend to go up over time.
NIIT is reported on Form 8960. Keep in mind that NIIT is not assessed against all of a taxpayer’s net investment income once it reaches the threshold, it is assessed against the lesser of the taxpayer’s net investment income or the amount by which the taxpayer’s MAGI exceeds the threshold. If that sounds confusing, just keep in mind that this is a good result—such that if a taxpayer’s MAGI was $1 over the threshold he or she would only pay NIIT on that $1 not on the entirety of his or her net investment income.
If you have any questions about NIIT, strategies to reduce your NIIT liability, or other tax strategies, feel free to contact me using the form below.