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How to Handle Net Investment Income Tax

As a financial planner, I occasionally get asked about the Net Investment Income Tax (NIIT), how it works and more importantly how to avoid it.

A bit of a mystery to most people, the NIIT is a tax on investment income that was introduced as part of the Affordable Care Act. It can be a confusing topic, but understanding how it works can help you plan your finances more effectively. Let's jump in.

What is Net Investment Income Tax (NIIT)

The NIIT is a 3.8% tax on your investment income. It applies to individuals whose income exceeds a certain threshold. The threshold is based on modified adjusted gross income (MAGI), which is your adjusted gross income (AGI) plus certain adjustments you add back in. The threshold is $200,000 for single filers and $250,000 for married couples filing jointly.

The NIIT is sometimes referred to as a Medicare tax because the proceeds go towards funding the Medicare program. The NIIT only applies if you have investment income and you are over the MAGI thresholds. The tax is calculated based on the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.

How MAGI Affects NIIT

As mentioned earlier, MAGI is your AGI with some modifications. To calculate your MAGI, you will need to add back deductions you took such as student loan interest, deductions for IRA contributions and deductions for foreign income. Your MAGI is important because it determines whether or not you are subject to the NIIT. If your MAGI is below the threshold, you will not owe the tax. However, if your MAGI is above the threshold, you will be subject to the tax on your net investment income.

Example of a single filer

Robert is a single taxpayer and makes $185,000 in salary. He also receives $10,000 of dividends and capital gains in the same year. Robert's modified adjusted gross income (MAGI) is $195,000, which is less than the $200,000 threshold. So Robert does not owe any net investment income tax.

Example 2 single filer

Mary is a single taxpayer and makes $185,000 in salary. She receives $30,000 of dividends and capital gains in the same year. Mary's modified adjusted gross income (MAGI) is $215,000, which exceeds the threshold of $200,000 for single taxpayers by $15,000.

Mary's net investment income is $30,000 (her dividends and cap gains).

The net investment income tax is based on the lesser of $15,000 (amount over the $200,000 threshold) or $30,000 (Mary’s net investment income).

Mary owes NIIT of $570 ($15,000 x 3.8%).

What's included in net investment income?

Net investment income includes a range of investment income sources. While not an exhaustive list, it includes capital gains, dividends, taxable interest, rental income and income from passive activities.

It is important to note that some types of investment income are not counted. For example, income from tax-exempt bonds, retirement accounts, pension income and life insurance proceeds. Additionally, capital gains from the sale of a primary residence are excluded from net investment income, up to a certain limit.

5 Star Tip: some items not counted as net investment income can still increase your MAGI and increase the odds of paying NIIT. Plan accordingly.

NIIT planning strategies

If you are subject to the NIIT, there are ways to minimize your tax liability. One strategy is to focus on tax-efficient investments. For example, investing in assets that generate little or no net investment income, such as tax-exempt bonds or growth stocks that do not pay dividends. You may also want to consider maximizing tax-deferred investment vehicles, such as IRAs or 401(k)s, to reduce your MAGI.

Another strategy is to time your capital gains and losses to minimize your net investment income in any given year. For example, you may want to sell assets that have lost value to offset gains from other investments. You could also consider deferring the sale of an asset until the following year to avoid triggering the NIIT.

NIIT and retirement planning

The NIIT can have an impact on retirement income. If you are subject to the tax, it could reduce the amount of income you have available in retirement. One way to address this is to plan in advance by using Roth IRAs and possibly Roth conversions over time. Roth accounts can generate tax-free income for you later in retirement that is not subject to the NIIT or is counted in MAGI. Be sure to consult with a tax advisor first as Roth conversions can cause taxes in the year of conversion. However the growth from that point on will be tax-free for qualified distributions.

Another strategy is to tax efficiently withdraw your income to help minimize or avoid triggering the NIIT. For example, using a combination of taxable and tax-free income sources to keep your MAGI below the threshold. You may want to use tax-deferred accounts to generate income early in retirement and then switch to tax-free accounts later on.

The Wrap

The Net Investment Income Tax is a complex and confusing topic in your financial plan. Understanding how the tax works and how it can be minimized can help you make better investment decisions and plan for a more secure retirement. If you are unsure about whether or not you are subject to the NIIT, or if you have questions about how it may impact your financial plan, I encourage you to reach out to me.

John Piershale, CFP®, AEP®

John Piershale Wealth Management, LLC is an Investment Adviser registered with the State of IL and in other jurisdictions where exempt from registration. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned. The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.


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