If you don’t know what Net Investment Income Tax (NIIT) is, you’re not alone. This relatively new tax began a little over a decade ago but the number of taxpayers subject to the tax has increased.
For instance, data show that 3.1 million taxpayers were subject to NIIT in its first year. Just eight years later, that number more than doubled.
So what is NIIT and who must pay it?
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Read on to avoid surprises on your next tax bill and to find out how you might lower your net investment income.
What is net investment income tax?
The net investment income tax is a 3.8% tax you must pay if your modified adjusted gross income (MAGI) exceeds a certain threshold. (More on that later).
Taxpayers meeting that income threshold pay the tax on the lesser of:
- Net investment income, OR
- The amount exceeding MAGI
The income thresholds are not indexed for inflation, meaning if inflation were to rise, you would pay a higher tax percentage on the same investment value.
Why am I paying net investment income tax?
Below are the MAGI thresholds that make you subject to NIIT:
- Married filing separately — income over $125k
- Single or Head of Household filers — income over $200k
- Married filing jointly — income over $250k
If you have investment income and your MAGI is less than the above amounts, you will not need to pay NIIT.
What counts as net investment income?
Different types of income may be subject to the 3.8% tax, though not all. Below is a list of common examples of investment income that fall under NIIT:
- Interest and dividends
- Capital gains
- Royalty and rental income
- Business trading income or other such passive income
Additionally, non-qualified annuities (mutual funds, CDs, etc.) may be subject to NIIT.
It’s important to consult with a tax professional to determine if an investment you hold is subject to a specific tax.
What is exempt from NIIT?
Several types of income are not subject to NIIT. For example, qualified annuities could be part of a retirement plan, so they may be subject to different tax rules. (For example: 401(k)s, 403(b)s, 457(b)s, and IRAs).
Other types of income generally exempt from NIIT include:
- Wages and unemployment compensation
- Social Security Benefits
- Alimony
- Tax-exempt interest (like municipal bond interest)
- Self-employment income
How to avoid the net investment income tax
Here are a few types of expenses that can help lower your net investment income. Keep in mind that these don't necessarily help you avoid the tax entirely. Rather, the expenses can help reduce your NII, potentially lowering NIIT liability.
- Investment interest expenses
- Investment advisory fees (or brokerage fees)
- Rental and royalty expenses related to your rental and royalty income
- Tax preparation fees
- Fiduciary expenses (for estates and trusts)
- Local income and state taxes
Next, we’ll use an example to demonstrate how investment income may be subject to the net investment income tax.
Net investment income tax example
Note: Keep in mind this is a simple example. Real-world scenarios can typically be more complex.
Example. A single filer has $175k in wages and $80k in dividends (with no expenses). This means their net investment income is $80k. Their MAGI (wages plus dividends) is $255k.
In this case, MAGI exceeds the threshold level for a single filer under NIIT ($200k). This means that the single filer will be subject to the tax.
NIIT will take the lesser of:
- The amount the taxpayer exceeds the threshold ($255k minus $200k = $55k), OR
- Their investment income ($80k)
Since $55k is less than $80k, NIIT will use $55k.
Thus, the taxpayer’s NIIT will be 3.8% multiplied by $55k, resulting in a tax of $2,090.
Does NIIT apply to home sales?
Generally, NIIT does not apply to items normally excluded from your regular taxable income, which includes the sale of a main residence.
If you plan to sell your principal home, the first $250k (single filer) or $500k (married filing joint) is generally exempt from capital gains tax. Hence, it is generally exempt from NIIT. But if the gain on the sale of your home is over the capital gains tax home exclusion limit, you may need to pay tax on the overage, hence, you could pay NIIT if your MAGI exceeds the threshold.
For more information see: Capital Gains Tax on Real Estate and Home Sales.
What is the 3.8% Medicare surtax?
If you are a taxpayer exempt from Medicare taxes, you may still owe NIIT if you meet the investment and MAGI criteria. While you may be subject to the .9% Medicare tax and the 3.8% investment tax, you will not be subject to both on the same type of income.
Note: Though both are surtaxes, they are distinct taxes with different rules. Also, a fun fact: the 'Medicare tax' doesn't currently fund Medicare. It's a separate tax that goes to the general fund.
For more information, see Medicare Tax: Five Things Every Worker Needs to Know.
IRS tax on net investment income: More information
If you'd like to learn more, the IRS has published a list of NIIT FAQs.
Additionally, you can find a withholding estimator on the IRS website that can help you estimate your federal income tax withholding, including NIIT.
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