Understanding the 3.8% Net Investment Income Tax

More On Tax Planning

from The Advisor's Professional Library
  • ETF Taxation The use of ETFs may be attractive to certain investors. The tax advantages may make them even more attractive.
  • IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.

The Net Investment Income Tax (NIIT) is a new tax that took effect on Jan. 1, 2013, so this is the first tax season in which taxpayers have to take it into account. However, because it is somewhat complex, we will divide it into two blog posts. In this post, we'll cover the rules and regulations and generally, how it works. Next week, we'll look at the steps involved in its calculation and discuss a few examples. 

What Is the NIIT? What’s Included?

The NIIT is a tax assessed on certain types of investment income at a rate of 3.8%. In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, nonqualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer (within the meaning of section 469). 

NOTE: Section 469 contains the passive activity loss rules. 

Common Types of Income Not Included

Certain income is not included in the calculation of NIIT. This includes, but is not limited to: wages, unemployment compensation; operating income from a non-passive business, Social Security benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul. 90-56, 1990-2 CB 102) and distributions from certain qualified plans as described in IRC sections 401(a), 403(a), 403(b), 408, 408A or 457(b).

Click to enlarge


The NIIT calculation is a bit complex, in that it involves several variables. In general, the amount of tax due on this type of income is calculated on the lesser of:
How Is the NIIT Calculated?

1) Amount of Modified Adjusted Gross Income (MAGI) which exceeds the applicable threshold (see Table below)

              Or 

2) Total Net Investment Income

Definition of MAGI

MAGI is adjusted gross income (from line 37 on Form 1040) increased by the difference between amounts excluded from gross income under section 911(a)(1) and the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) for amounts described in section 911(a).

NOTE: IRS Section 911 pertains to American citizens earning income while living abroad. Hence, for the majority of taxpayers, MAGI will be the same as AGI. 


What Are the Applicable Income Thresholds?

The applicable threshold for each filing status is as follows: 

TABLE B: Thresholds

Filing Status

Threshold

Head of Household

$200,000

Married Filing Jointly

$250,000

Married Filing Separate

$125,000

Single

$200,000 

The thresholds are not indexed for inflation. Therefore, in subsequent years more and more taxpayers will be subject to this tax. 

Summary

Those are the basic rules, but there is one additional point which needs to be made: The sale of a personal residence could trigger the NIIT. How? We'll discuss this next week as we consider a few examples. We'll also look at the steps involved in calculating this tax and what we, as advisors, should be telling our clients.

---

For more tax planning advice, see our special report, 21 Days of Tax Planning Advice for 2014.

Close single page view Reprints Discuss this story
This is where the comments go.