The net investment income tax is a 3.8 percent surtax on a percentage of your MAGI that exceeds specific levels. It is typically paid by high-income earners with substantial investment income.
Even if you use deductions, credits, and other tax breaks to avoid paying considerable income taxes on your investment income, the net investment income tax may still apply to your finances. This article will explain what net investment income tax is, how it works and who is responsible for paying it.
What Is Investment Income?
Investment income includes interest payments, dividends, capital gains earned from the sale of shares or other assets, and any additional profit made via the use of an investment vehicle.
Investment income includes interest gained on bank accounts, dividends obtained from stock owned through mutual fund holdings, and profits from the selling of gold coins.
Income from long-term investments is taxed differently – and frequently preferentially – depending on the country and area.
Understanding Investment Earnings
The term “investment income” refers primarily to financial gains over the initial cost of the investment.
The type of the income, such as interest or dividend payments, is unimportant in determining whether it is deemed investment income, as long as it is earned from a previous investment.
Furthermore, investment income can be obtained in the form of a single payment or as recurring interest installments paid out over time.
Most people generate the majority of their net income each year through regular employment income. Disciplined saving and investing in financial markets, on the other hand, can turn modest savings into huge investment portfolios, delivering an individual a sizable annual investment income over time.
Investments are a common source of revenue for businesses. An item called investment income or losses is typically shown on the financial statements of publicly traded firms. This is where the company declares the portion of its net income that was achieved through investments made with extra funds rather than through its normal line of business.
For a company, this might include all of the above, as well as the interest gained or lost on its bonds, share buybacks, corporate spinoffs, and acquisitions.
Interest earned on a basic savings account is regarded as investment income. The interest is earned in addition to the initial investments, which are the deposits made into the account. As a result, the account is a source of revenue.
Investment income can also be generated by options, equities, and bonds. Whether through recurring interest or dividend payments or by selling an asset at a greater price than paid for it, cash received in excess of the investment’s original cost qualify as investment income.
What is Net Investment Income?
Net investment income (NII) is the income earned from investment assets such as bonds, equities, mutual funds, loans, and other investments before taxes (less related expenses). Individual tax rates on net investment income vary depending on whether the income is interest, dividends, or capital gains.
Understanding Net Investment Income (NII)
When investors sell assets from their portfolios, the transaction proceeds result in either a realized gain or loss. Capital gains from the sale of stock; interest income from fixed income products; dividends paid to firm shareholders; rental income from property; some annuity payments; royalty payments, and so on are examples of realized gains. The net investment income is the difference between any realized gains (before taxes) and any trade commissions or fees (NII). Depending on whether the asset was sold for a capital gain or loss, NII could be positive or negative.
What is Net Investment Income Tax?
The net investment income tax (NIIT) is a 3.8 percent tax on investment income that usually only applies to high-income people. Individuals, families, estates, and trusts are all subject to the tax, although certain income levels must be fulfilled before the tax becomes effective.
Capital gains, interest, and dividends are all examples of net investment income. It can include rental income, capital gain dividends from mutual funds, royalty or annuity income, and interest on loans you may have made to others.
It comprises passive revenue from a trade or business, as well as income from a business selling financial instruments or commodities.
The History of the Net Investment Income Tax
As part of the Health Care and Education Reconciliation Act of 2010, the net investment income tax was enacted.
It becomes effective on January 1, 2013. This Act, together with the Affordable Care Act, altered the healthcare market by mandating individuals to buy health insurance or face a tax penalty.
To generate revenue, the net investment income tax was inserted in the Act. The Joint Committee on Taxation anticipated that the net investment income tax, when combined with the Additional Medicare Tax, would raise billions of dollars in tax revenue in 2013, the first year that this surtax would be in force.
The net investment income tax is officially known as the “Unearned Income Medicare Contribution Tax.”
This implies that the tax revenue is used to support Medicare, but the tax revenue is used to fund the nation’s general fund.
In reality, because these two taxes apply to distinct sorts of income, you may be subject to the net investment income tax even if you are exempt from the Additional Medicare tax.
How the Net Investment Income Tax Works
When a taxpayer sells almost any sort of investment, they will either experience a gain or a loss—they will make money if they sell for less than what they invested in the asset or they will lose money if they sell for less than what they put in the item.
There are, however, some exceptions.
Net investment income does not include tax-free interest. Gains from the sale of a personal residence are also exempt where the gain is deducted from income for income tax purposes.
Gains on property held in the course of a trade or business are likewise exempt.
How to Manage Net Investment Income Tax
Just because you make a lot of money and have a lot of investment income doesn’t imply you have to pay a lot of NIIT.
You can manage your net investment income tax burden by reducing the amount of net investment income reported as well as your modified adjusted gross income.
Chris Schiffer of the Wealth Enhancement Group in Basking Ridge, N.J., advises, however, that “the tax tail should not wag the investing dog.”
But if you’re in charge of the leash, here’s what you can do.
Capital Gains Should Be Timed
If possible, Schiffer advises paying close attention to the timing of capital gains recognition. You may be able to time the selling of stocks that have had major profits with the sale of those that have experienced significant losses.
This is a practice known as tax-loss harvesting, and it can help you reduce your net income.
If your income varies greatly from year to year, you may be able to schedule the sale of your securities for years when your MAGI is less than the NIIT requirement, according to Schiffer.
Make Use Of Charitable Contributions
However, if you are unable to postpone realizing your advantages, you are not without options. Charitable contributions may allow you to minimize your net investment income.
If you’re already going to make charitable contributions, consider if you may substitute cash donations for donations of appreciated securities. This way, you won’t have to report again on your tax return and you’ll still be able to take advantage of the tax deduction from the charitable gift.
In addition, to limit NIIT’s obligation, you may want to consider establishing a charitable remainder trust (CRT). “A CRT is an irrevocable, tax-exempt trust in which the grantor deposits assets to pay income over a specified period.”
“CRTs are excluded from Clause 1411 [the tax code section that pertains to the NIIT], which means that gains sold by the CRT are not subject to the net investment income tax,” Schiffer adds.
Adjust Your Magi
If none of those approaches work for you, calculate your modified adjusted gross income instead. If you rely on fixed-income investments, municipal bonds should be considered over other bond kinds.
These instruments are exempt from federal taxation and, in most cases, from state income tax if they are issued in the state where the taxpayer resides.
Growth stocks, which normally do not pay dividends and will not affect your MAGI until you sell them and realize gains, are another investment that can assist reduce MAGI. Whole life policies that grow cash value and tax-deferred annuities do not produce taxable income until they are withdrawn.
Importantly, seek to contribute as much as possible to tax-advantaged retirement vehicles such as 401(k) and SEP plans. Donations to these accounts, unlike IRA contributions, reduce your MAGI.
How Do I Pay the Net Investment Income Tax?
If you are subject to the net investment income tax, include IRS Form 8960 with your tax return. The form includes instructions to assist you to figure out how much you owe, and it may be used by both people and estates or trusts.
Remember that if you owe this tax, you must make quarterly estimated payments on the amount you believe you will owe in addition to any quarterly income payments.
How to Calculate Net Investment Income Tax
The net investment income tax is a 3.8 percent surtax added to regular income taxes. However, not everyone who earns a living from their investments is affected. It only applies to incomes above the aforementioned criteria.
In practice, this means that you’ll need your modified adjusted gross income (MAGI) in addition to your net investment income to calculate your NIIT. Here’s how to figure out both.
How to Determine Net Investment Income
Net investment income is calculated by aggregating all of your investment revenue from the previous tax year and subtracting any related expenses.
Profits realized while selling investments, dividend and interest payments received, and income from rental properties are all examples of investment income as defined by the IRS.
Commissions and tax preparation costs are examples of related charges.
Modified Adjusted Gross Income Calculation (MAGI)
MAGI is a household’s adjusted gross income after tax-exempt interest payments and certain deductions, such as student loan interest payments and IRA contributions, are deducted.
Line 11 of the 2020 Form 1040 contains your adjusted gross income. Deductions such as student loan interest payments, tuition expenses, IRA contributions, taxable Social Security payments, the deduction for self-employment taxes, and rental losses must then be subtracted.
Deductions that apply will be shown on Schedules 1, 2, and 3 of Form 1040.
Calculating Net Investment Income Tax
Now that we have the components, let us compute NIIT. If your MAGI exceeds the above-mentioned criteria, you will almost certainly be subject to net investment income tax and will need to calculate NIIT on Form 8960.
It is not as straightforward as multiplying your net investment profits by 3.8 percent to calculate NIIT. You get a pass from the IRS. You are charged 3.8 percent of net investment income or the amount by which your MAGI exceeds the income thresholds required to incur NIITs.
For example, if you were a single filer earning $250,000 and $25,000 of that was net investment income, your NIIT would be calculated solely on the income from your investments.
This is because $25,000 is less than $50,000—the difference between the $200,000 and $250,000. The cost of your NIIT would then be $950.
If you made $75,000 in net investment income but had the same MAGI, your NIIT would be calculated based on the $50,000 you earned above the cutoff. Your NIIT would be $1,900 in that situation.
MAGI is the same as AGI for the vast majority of taxpayers. This is because the only adjustments required to AGI to arrive at MAGI are for overseas earned income.
Any taxpayer with net investment income (of any amount) and modified adjusted gross income (MAGI) over $200,000 for single filers, $125,000 for married filers filing separately, and $250,000 for married couples filing jointly. Unlike many other income threshold numbers, these are not updated for inflation on an annual basis.
Section 1411 of the Internal Revenue Code imposes the Net Investment Income Tax. The NIIT is levied at a rate of 3.8 percent on certain net investment income of persons, estates, and trusts with income more than the statutory thresholds.
No, but you can request that additional income tax be withheld from your paycheck.
In general, investment income includes, but is not limited to, interest, dividends, capital gains, rental and royalty income, non-qualified annuities, revenue from firms that trade financial instruments or commodities, and income from businesses that are passive to the taxpayer.
When was the Net Investment Income Tax enacted?
On January 1, 2013, the Net Investment Income Tax went into force. Individuals, estates, and trusts are affected by the NIIT beginning with their first tax year commencing on (or after) January 1, 2013.
It does not affect income tax returns filed in 2013 for the 2012 taxable year.
What are some examples of frequent sources of income that do not qualify as Net Investment Income?
Wages, unemployment benefits, operational income from a nonpassive business, Social Security benefits, alimony, tax-free interest, self-employment income, Alaska Permanent Fund Dividends
Is the tax required to be withheld from wages?
No, but you can request that additional income tax be withheld from your paycheck.
What types of people are exempt from the Net Investment Income Tax?
The Net Investment Income Tax (NIIT) does not apply to nonresident aliens (NRAs). If an NRA is married to a U.S. citizen or resident and has made, or intends to make, an election under IRC section 6013(g) to be treated as a resident alien for filing as Married Filing Jointly, the proposed regulations provide special rules for these couples, as well as a corresponding IRC section 6013(g) election for the NIIT.
What types of estates and trusts are liable to the Net Investment Income Tax?
Estates and trusts are subject to the Net Investment Income Tax if they have undistributed Net Investment Income and adjusted gross income that exceeds the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for the tax year 2012, this figure is $11,650).
The proposed regulations include particular computational requirements for some types of trusts, such as Charitable Remainder Trusts and Electing Small Business Trusts.
A capital gain occurs when you profit from the sale of investments. Furthermore, you must pay a capital gains tax on the capital gain. Some people who owe capital gains tax also owe NII tax.
You must pay taxes on everything, whether you are a business owner or an individual taxpayer (including a tax on investment income). However, the type of tax you pay is determined by how you earn the money.
As a result, this tax only applies in limited circumstances.