During the last several years, the 3.8% net investment income tax (NIIT) has ensnared a steadily increasing number of taxpayers. Why? Because when the tax was enacted 11 years ago it applied to “high earners” — defined as single filers with modified adjusted gross income (MAGI) over $200,000 and joint filers with MAGI over $250,000. Those thresholds have never been adjusted for inflation. As a result, the number of taxpayers liable for NIIT has more than doubled during that time.
If you fall into the “high earner” bracket, familiarize yourself with the NIIT. The good news is there may be strategies you can use to reduce, or even eliminate, this tax.
NIIT explained
Net investment income (NII) is gross income (less allowable expenses) from taxable interest, dividends, capital gains, rents, royalties and passive business interests. It doesn’t include wages, income from a business you actively manage (except for trading financial instruments or commodities), tax-exempt interest, taxable distributions from IRAs or qualified retirement plans, and Social Security benefits, among other things.
Also excluded from NII is the tax-exempt portion of your net gain on the sale of a principal residence ($250,000 for single filers; $500,000 for joint filers). But to the extent your gain exceeds the exemption amount, it’s subject to NIIT.
If your MAGI (for most people, MAGI is the same as adjusted gross income) exceeds the applicable threshold, the NIIT applies to the lesser of 1) your NII, or 2) the amount by which your MAGI exceeds the threshold. Suppose, for example, that Mary, a single filer, typically earns MAGI of $175,000, consisting of $150,000 in wages and $25,000 in interest and dividends. In 2023, she sells stock at a gain of $75,000, so her MAGI for 2023 is $250,000 ($175,000 + $75,000) and her NII for 2023 is $100,000 ($25,000 + $75,000). The NIIT applies only to the $50,000 in income above the $200,000 MAGI threshold — for an additional tax of $1,900 ($50,000 × 3.8%).
What if Mary’s wages were over $200,000? In that case, the entire $100,000 in NII would be taxable, so she’d owe $3,800 in NIIT.
Strategies for reducing NIIT
Tax planning strategies for reducing NIIT generally fall into two categories:
- Strategies that reduce your NII, and
- Strategies that reduce your MAGI.
Depending on your income level, reducing MAGI can lower your NIIT by reducing the amount by which your MAGI exceeds the threshold. For example, suppose Mark and Donna, a married couple filing jointly, have MAGI of $350,000, consisting of $250,000 in wages and $100,000 in NII. If they reduce their NII by $25,000 to $75,000, they’ll save $950 in NIIT ($25,000 × 3.8%). Reducing their MAGI by $25,000 will have the same effect, even if their NII remains the same, because the excess of their MAGI over the threshold will drop to $75,000.
Potential strategies for reducing NII include:
- Reducing capital gains by harvesting losses — that is, selling stocks or other securities that have declined in value — and offsetting those losses against gains,
- Reducing interest income by shifting investments into tax-exempt municipal bonds,
- Reducing dividends by shifting investments into growth stocks that pay low or no dividends, and
- Transferring income-producing investments to children or other family members in lower tax brackets.
Potential strategies for reducing MAGI include:
Increasing tax-deductible contributions to traditional IRAs, 401(k) plans, Health Savings Accounts or similar accounts. These are “above-the-line” deductions that reduce gross income. Below-the-line deductions — such as mortgage interest, medical expenses and charitable donations — don’t affect gross income and, therefore, can’t reduce NIIT.
Making qualified charitable distributions from a traditional IRA. If you’re over 70½ and charitably inclined, you can donate up to $100,000 per year directly from your IRA to one or more qualified charities. These donations reduce the amount of any required minimum distributions you’d otherwise have to take, keeping those funds out of your gross income.
Converting traditional IRAs into Roth IRAs. (See “Can a Roth IRA conversion reduce NIIT?” below.)
Often, people who aren’t ordinarily subject to NIIT find themselves liable for the tax because of a significant one-time gain — for example, the sale of a large holding of appreciated securities. In those cases, it may be possible to reduce, or even eliminate, NIIT by spreading the sale over two or more years.
Consider NIIT when making investment decisions
The NIIT is a relatively small tax, but it can have a big impact on your investment decisions. Say you’re comparing a taxable bond to a similar tax-exempt municipal bond. To be sure you’re comparing apples to apples, ask your tax advisor to calculate the tax-equivalent yield — that is, the return the taxable bond must earn so that it’s after-tax yield is equal to the yield on the municipal bond. Whether the taxable bond is subject to the NIIT can be a significant factor.
Can a Roth IRA conversion reduce NIIT?
When you convert a traditional IRA to a Roth IRA, you’re immediately subject to tax on the converted amount (to the extent that it’s attributable to deductible contributions and earnings on those contributions). So, if you’re contemplating such a conversion, you need to compare the current tax cost with the tax savings you’ll enjoy in the future. Qualified withdrawals from Roth IRAs are tax-free, and Roth IRAs aren’t subject to the required minimum distribution rules.
As you compare the relative costs and benefits, consider the potential impact of the 3.8% net investment income tax (NIIT). Although distributions from a traditional IRA aren’t subject to NIIT, they do increase your modified adjusted gross income, which can trigger or increase the NIIT.
This is true for the conversion to a Roth IRA. Distributions from Roth IRAs are excluded from gross income, so they aren’t subject to NIIT. Whether the Roth conversion ultimately reduces NIIT depends on factors such as whether the conversion increased the NIIT that was due at that time. It also depends on whether — and to what extent — taking a distribution from the Roth IRA allows you to reduce the NIIT that would have been owed if you’d taken the same distribution from a traditional IRA.
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