3.8% Net Investment Income Tax

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Investment Income – Do I have to pay an additional tax?

You might, depending on a few important factors.

A 3.8% net investment income tax is imposed on the unearned income of high-income individuals. The tax is applied to an amount equal to the lesser of:

  • Your net investment income
  • The amount of your modified adjusted gross income (basically, your adjusted gross income increased by an amount associated with any foreign earned income exclusion) that exceeds $200,000 for a single person ($250,000 if married filing a joint federal income tax return, and $125,000 if married filing a separate return)

So if you’re single and have a MAGI of $250,000, consisting of $150,000 in earned income and $100,000 in net investment income, the 3.8% tax will only apply to $50,000 of your investment income.

The 3.8% tax also applies to estates and trusts. The tax is imposed on the lesser of undistributed net investment income or the excess of MAGI that exceeds the top income tax bracket threshold for estates and trusts ($12,150 in 2014). This relatively low tax threshold potentially could affect estates and trusts with undistributed income. Consult a tax professional.

What is net investment income?

Net investment income generally includes all net income (income less any allowable associated deductions) from interest, dividends, capital gains, annuities, royalties, and rents. It also includes income from any business that’s considered a passive activity, or any business that trades financial instruments or commodities.

Net investment income does not include interest on tax-exempt bonds, or any gain from the sale of a principal residence that is excluded from income. Distributions you take from a qualified retirement plan, IRA, 457(b) deferred compensation plan, or 403(b) retirement plan are also not included in the definition of net investment income.

If you are subject to the 3.8% net investment income tax, there are strategies to consider that may help you manage that tax.

Strategies on how to manage the net investment income tax

If you are subject to the 3.8% net investment income tax, there are strategies  that may help you manage that tax. The tax is applied to the lesser of your net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds the applicable income tax threshold. MAGI is basically adjusted gross income plus any associated foreign earned income exclusion. Any strategy you consider should be directed at the appropriate target.

If your net investment income is greater than your MAGI over the threshold, then your focus should be aimed at reducing your MAGI. Conversely, if your MAGI over the threshold is greater than your net investment income, you should try to reduce your net investment income.

Here are a few strategies that may help you manage the net investment income tax:

  • Before selling appreciated securities, consider whether you can offset the gain with capital losses.  Likewise, if you have any capital loss carryforwards, you should review your portfolio for capital gain opportunities to make use of the capital losses.
  • Consider gifts of appreciated securities to tax-qualified charities.
  • If passive income is from a business, offset passive income with passive losses. If you don’t have passive losses, you may be able to convert the passive income to non-passive income (not subject to the tax) by becoming more active in the business.
  • You may be able to reduce your MAGI by increasing contributions to a traditional IRA, 401(k), or 403(b).
  • Consider investments that may have growth potential but typically do not generate dividends.
  • Generally, any gains in tax-deferred annuities and cash value life insurance are not reportable as income unless withdrawn, which may help reduce both your MAGI and your net investment income.

While any of these alternatives may help reduce your net investment income or your MAGI, they may also affect your financial planning. So before implementing strategies  to reduce or eliminate exposure to the net investment income tax,  consult with a tax professional to help with your specific situation.