1. What is net investment income?
Net investment income is the tax base for the 3.8% net investment income tax. In general, net investment income potentially includes any income other than “earned” income that is subject to Social Security tax and Medicare tax.
There are three general categories of net investment income: income commonly considered to be traditional investment type income, such as interest, dividends, annuities, rents and royalties; gross income derived from a trade or business; and net gain attributable to the disposition of property.
2. What is modified adjusted gross income for purposes of the NIIT?
For most taxpayers, MAGI is the same as their AGI. This is because the only adjustments made to AGI in arriving at MAGI relate to foreign earned income.
3. Who is liable for paying the net investment income tax?
Any taxpayer who has net investment income (in any amount) and modified adjusted gross income (MAGI) in excess of $200,000 for single taxpayers, $125,000 for married taxpayers filing separately and $250,000 for married couples filing jointly. Unlike many other income threshold amounts, these thresholds are not indexed annually for inflation.
In addition to individuals, the net investment income tax applies to certain trusts and estates. Nonresident aliens are not subject to the tax.
4. Can conversion from a traditional IRA to a Roth IRA cause an individual to indirectly become subject to the NIIT?
Officially, distributions from traditional retirement accounts (IRAs, 401(k)s) are excluded from the NIIT. Similarly, amounts that are rolled over into Roth accounts from these traditional accounts are technically excluded. But these amounts still count in determining an individual’s AGI — and can cause the individual to exceed the applicable threshold and become subject to the NIIT.
As a result, for some individuals, Roth conversions are best exercised in small steps over time —converting only a small portion of traditional retirement funds each year to avoid crossing the AGI threshold. For others, Roth conversions may no longer be the best option for generating tax-free income during retirement.
5. How does the NIIT effectively increase the tax rate for capital gains and dividends?
The 3.8% net investment income tax is a surtax, meaning it is imposed independently on net investment income that is also subject to any other applicable income tax. To illustrate, the capital gains and dividend tax rate for taxpayers in the 39.6% tax bracket is 20%. However, if the taxpayer is also subject to the net investment income tax, there is an additional 3.8% tax imposed on those same capital gains and dividends. Thus, adding the two tax rates together, the overall effective tax rate for capital gain and dividends for those taxpayers is 23.8%.
For taxpayers who are not in the 39.6% tax bracket, the capital gains and dividend tax rate is only 15%. However, it is possible that such taxpayers with modified AGI that exceeds the threshold levels for the net investment income tax may also be subject to the net investment income tax. Adding the 15% regular income tax capital gain and dividend rate to the 3.8% net investment income tax rate, the effective rate of such taxpayers would be 18.8%.
6. Can federal income tax credits be used to offset NIIT liability?
Although federal income tax credits can offset any tax liability, the final regulations state that income tax credits are allowed only against regular income tax and may not reduce net investment income tax. Examples of this type of tax credit include the foreign income tax credit and the general business tax credit.
The denial of tax credits as an offset of the NIIT is reflected by the sequence of reporting tax and tax credits on Form 1040. To this point, regular income tax is reported on line 46 of Form 1040. All tax credits reducing that regular income tax are taken lines 47-53. Beginning on line 56, “other taxes,” including the NIIT (reported on line 60), are reported. So logistically, all tax credits that reduce regular income tax are taken before the entry for the NIIT.
7. What form is used to report NIIT?
Net investment income tax is reported on line 60 of Form 1040. On Form 8960 (attached to Form 1040), the taxpayer computes the tax. In addition to reporting all the taxpayer’s net investment income, amounts reported on Form 8814 (Parents’ Election to Report Child’s Interest and Dividends) are also included.
Similar to regular income tax or self-employment tax, individuals who expect to be liable for the NIIT may either make estimated tax payments or request that their employer withhold additional amounts to avoid being subject to penalties for underpayment of taxes.
8. Which trusts are not subject to the NIIT?
Trusts not subject to the net investment income tax include charitable trusts exempt from tax under IRC Section 501 or IRC Section 664 (charitable remainder trusts) and trusts that are not classified as “trusts” for federal income tax purposes. Moreover, if all of the remaining interests in a trust are designated for certain qualified purposes, the trust is not subject to the NIIT. These qualified purposes described in IRC Section 170(c)(2)(B) include religious, charitable, scientific, literary or educational purposes.
Finally, grantor trusts such as revocable trusts are not subject to the NIIT. This is because the income of a grantor trust is taxed directly to the grantor. As a result, any net investment income generated by the trust is included in the grantor’s net investment income — potentially subject to the 3.8% tax at the individual level.
9. What is the additional Medicare tax? Who is liable for paying it?
The additional Medicare tax is a tax of 0.9% that is tacked on to the “regular” Medicare tax on all wages and self-employment income (collectively referred to as “earned income”) that exceed applicable threshold amounts. Thus, on earned income in excess of the applicable threshold amount, the total Medicare tax rate is 3.8% (the 2.9% regular Medicare tax rate plus the 0.9% additional Medicare tax rate).
In spite of its name, the tax revenue generated by the additional Medicare tax is not specifically earmarked for the Medicare fund. Similar to the regular Medicare tax, the additional Medicare tax is imposed only on individual taxpayers. Thus, entities such as C corporations, trusts and estates are not subject to the tax.
10. What are the consequences of an employer’s failure to withhold the additional Medicare tax that an employee is liable to pay?
This scenario might occur if, for example, each spouse individually earns wages under the mandatory $200,000 withholding amount. If one spouse has wages of $100,000 and the other spouse has wages of $199,000, neither spouse’s wages are subject to mandatory withholding. However, because the couple’s combined wages of $299,000 exceed the $250,000 applicable threshold by $49,000, they must pay the additional Medicare tax on that amount. Thus, on Form 8959, the couple would compute the additional Medicare tax of 0.9% on $49,000 — reporting it on line 60 of Form 1040.
11. Can a taxpayer request additional withholding specifically earmarked to pay anticipated additional Medicare tax?
No, a taxpayer cannot make such a request. However, the taxpayer may modify Form W-4 to request that his or her employer withhold additional income tax. Even though the additional amount withheld is technically regular income tax (not additional Medicare tax), it is nonetheless credited as a payment to be applied to all Form 1040 tax liability owed, including the additional Medicare tax.