Net Investment Income Tax

The Net Investment Income Tax (NIIT) is a federal tax imposed on certain investment income earned by individuals, estates, and trusts in the United States. It was introduced as a part of the Affordable Care Act (ACA) in 2013, and it helps fund healthcare initiatives.

The tax applies to individuals with modified adjusted gross incomes (MAGI) over a specified threshold. The investment income subject to NIIT includes capital gains, dividends, interest, and rental income. The tax rate is 3.8% of the lesser of either the net investment income or the amount by which MAGI exceeds the threshold.

The Net Investment Income Tax (NIIT) is a vital element of federal tax in the United States. It was introduced as part of the Affordable Care Act (ACA) in 2013. It is designed to generate additional revenue to support healthcare initiatives. NIIT is a federal tax that applies to certain investment income earned by estates, individuals, and trusts.

The primary purpose of net investment income tax is to target high-income earners who gain a significant portion of their income from investments. It imposes a 3.8% tax on certain investment income. This tax aims to generate additional revenue to support healthcare programs and increase access to healthcare services for Americans. Furthermore, the tax addresses income inequality by requiring those with high investment income to contribute a portion of their earnings to help fund healthcare initiatives for the broader population.

The steps to calculate net investment income tax are discussed below:

• Individuals must start by calculating the MAGI, including their adjusted gross income (AGI), with specific modifications. These modifications may include adding back items like foreign income, tax-exempt interest, and excluded gain from the sale of a principal residence.
• Next, they must identify the types of investment income subject to NIIT. These include interest, dividends, capital gains, rental income, and certain passive business income.
• After determining the investment income, individuals must calculate their net investment income (NII). They may calculate it by adding all their investment income sources and subtracting any deductions related to it. Deductions may include investment interest expenses, investment advisory fees, and other expenses directly associated with producing the investment income.
• Then, they must subtract the threshold that applies to their filing status from their MAGI. Thus, the resulting number will indicate the amount the MAGI exceeds the threshold.
• The NIIT is 3.8% of the lesser of the NII or the excess MAGI.
• Finally, individuals must report their NIIT liability on Form 8960 while preparing the federal income tax return. If they owe NIIT, it will be added to their overall tax liability. It must be paid along with their regular income tax when they file the return.

Let us study the following examples to understand this tax:

Example #1

Suppose David had a modified adjusted gross income of $220,000 for a particular year. It exceeded the NIIT threshold for individuals of $200,000. He also had $30,000 in net investment income for the year. This amount included interest, dividends, and capital gains from his investments. To calculate his NIIT liability, he estimated the excess MAGI by subtracting his MAGI from the threshold.

Thus, $220,000 - $200,000 = $20,000.

Then, he determined the lesser of his net investment income or the excess MAGI. In his case, the net investment income was $30,000, which was higher than the excess MAGI of $20,000. Furthermore, he applied the NIIT rate of 3.8% of the lesser amount. So, 3.8% of $20,000 = $760.

Therefore, his NIIT is $760.

Example #2

Reports have shown that the returns from the NIIT surtax have increased more than twice over the last decade. As a result, the revenue from the tax has increased by $38 billion.

Investment expenses can reduce taxable income. Despite wage and income growth, the thresholds have not been adjusted for inflation, increasing taxpayers subject to the tax. Republican and Democratic lawmakers have proposed changes, with Republicans seeking to raise the joint filer threshold to $400,000 and index thresholds to inflation.

At the same time, the US President aims to increase the rate to 5% for incomes over $400,000, expand the tax to more business income, and allocate revenues to support Medicare's Hospital Insurance Fund. Moreover, Biden suggested that the surtax should cover more business income.

Some ways to avoid the NIIT are:

• Individuals may keep their modified adjusted gross income below the applicable thresholds. By managing their income below these levels, they can prevent NIIT from applying to their investments.
• They may consider diverting some of the investments into tax-advantaged accounts like Individual Retirement Accounts (IRAs), 401(k)s, or Health Savings Accounts (HSAs). Earnings within these accounts generally accumulate tax-free or tax-deferred until withdrawal, which can help shield investments from the NIIT.
• Investing in tax-exempt securities, like municipal bonds or municipal bond funds, may help avoid this tax. Interest income from these bonds is generally exempt from NIIT.
• Gifting appreciated assets or property to family members or heirs in lower tax brackets can help individuals avoid this tax. They can shift the investment income and capital gains to individuals not subject to NIIT by transferring the ownership of the properties and assets.
• Strategically timing the realization of capital gains will aid in eliminating this tax. If an individual anticipates their MAGI to be lower in a particular year, they may consider selling assets with capital gains to reduce the NIIT liability. However, if they expect higher MAGI, they may postpone the sale of such assets to minimize their exposure to NIIT.

Some net investment income tax exclusions are as follows:

• Interest income from municipal bonds and certain other tax-exempt bonds is excluded from NIIT. This means that the interest earned from these bonds is not considered part of the net investment income and is not subject to tax.
• Distributions from qualified retirement accounts like traditional IRAs, Roth IRAs, 401(k)s, and similar plans are usually not included in the calculation of net investment income and are exempt from NIIT.
• Income generated from an active trade or business in which an individual materially participates is not considered net investment income and is therefore exempt from NIIT. This can include income from sole proprietorships and partnerships if the individual is actively involved in the business's operations.
• Individuals who qualify as "real estate professionals" and actively participate in rental real estate activities can exclude rental income from NIIT. To qualify, they must meet specific criteria, like spending significant time in real estate activities and meeting certain thresholds.

The differences between the two are as follows:

Net Investment Income Tax

• It applies to specific types of investment income, including interest, dividends, capital gains, rental income, and some passive business income. It is aimed at individuals with modified adjusted gross incomes (MAGI) above certain thresholds.
• NIIT is levied at a rate of 3.8% on the lesser of the net investment income or the amount by which the MAGI exceeds the threshold.
• It was introduced to help fund healthcare initiatives under the ACA. It primarily affects higher-income individuals who derive a significant portion of their income from investments.
• There are specific exclusions and exemptions within NIIT, like tax-exempt interest income, qualified retirement account distributions, and active trade or business income. These exemptions can reduce or eliminate the tax liability for certain types of income.

Capital Gains Tax

• Capital gains tax applies to the profits earned from selling capital assets like stocks, real estate, and other investments. It encompasses both short-term and long-term capital gains. The tax treatment can vary based on the holding period and overall income.
• It is levied on the profit made when an individual sells an asset for more than its original purchase price.
• The tax rate on capital gains depends on factors like overall taxable income, the asset's holding period, and the type of asset. Generally, long-term capital gains receive preferential tax rates, which can be 0%, 15%, or 20%, depending on the income.
• This tax is a significant revenue source for the government and acts as an instrument to generate funds from the appreciation of market assets. It encourages investment while taxing the gains made from those investments.