For high-income taxpayers, there’s already a regular tax rate of 35% or 37%. In addition to this, they might be required to pay a 3.8% net investment income tax (NIIT) on top of regular income tax. Luckily, there are a few ways you may be able to reduce the impact of the NIIT.
Who are the affected taxpayers?
The NIIT applies to you only if your modified adjusted gross income (MAGI) is greater than:
- $250,000 for married taxpayers filing jointly and surviving spouses
- $200,000 for unmarried taxpayers and heads of household
- $125,000 for married taxpayers filing separately
The total amount that is subject to the tax is the lesser of your net investment income or the amount by which your MAGI exceeds the threshold that applies to you.
Net investment income includes dividend, interest, royalty, annuity, and rental income—unless those items were acquired in the ordinary course of an active trade or business. Additionally, other gross income derived from a passive activity in a trade or business, as well as income from a business trading in financial instruments or commodities, are all subject to the NIIT.
Which items are exempt?
There are various forms of income that are exempt from the NIIT. For instance, tax-exempt interest and excluded gain from the sale of your main place of residence aren’t subject to the tax.
Distributions from qualified retirement plans are not subject to the NIIT either. Social Security benefits are also excluded. Wages and self-employment income are also not subject to the NIIT, although they may be subject to a different Medicare surtax.
It’s essential to remember that the NIIT applies only if you possess net investment income and your MAGI exceeds the relevant thresholds mentioned above. With that said, you can still reduce your net investment income by implementing certain strategies.
Shifting your investments
If your income is substantial enough to trigger the NIIT, reallocating some income investments to tax-exempt bonds could lead to reduced exposure to the tax. Tax-exempt bonds reduce your MAGI and help you to avoid the NIIT.
As a result of the NIIT, dividend-paying stocks are more heavily taxed. The maximum income tax rate on qualified dividends is only 20%, but that rate increases to 23.8% with the NIIT.
Consequently, you might want to consider rebalancing your investment portfolio to prioritize growth stocks over dividend-paying stocks. While the capital gains from these investments will be included in the net investment income, there are two potential advantages:
- The tax will be deferred because the capital gains won’t be subject to the NIIT until the stocks are sold
- Capital gains can be offset by capital losses, which isn’t the case with dividends
Retirement plan distributions
Since distributions from qualified retirement plans are exempt from the NIIT, high-income taxpayers who have some control over their circumstances (such as small business owners) might want to consider making greater use of qualified plans.
Have questions? Smolin can help
These are just a few of the strategies you may be able to employ to offset the NIIT. You may also be able to make moves related to passive activities, charitable donations, and rental income that might help you minimize the NIIT.
If you’re subject to the tax and want to know how to offset its impact, contact the knowledgeable professionals at Smolin, and we’ll walk you through the process.