Planning for Net Investment Income Taxes
Despite its name, the Tax Cuts and Jobs Act (TCJA) left several taxes unchanged, including the 3.8% tax on net investment income (NII) of high-income taxpayers. Fortunately, there are some strategies you can use to soften the blow of NII taxes.
Are you subject to the tax?
You’re potentially liable for NII taxes if your modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for joint filers and qualifying widows or widowers; $125,000 for married taxpayers filing separately). Generally, MAGI is the same as adjusted gross income. However, it may be higher if you have foreign earned income and certain foreign investments.
To calculate the tax, multiply 3.8% by the lesser of 1) your NII, or 2) the amount by which your MAGI exceeds the threshold. For example, if you’re single with $250,000 in MAGI and $75,000 in NII, your tax would be 3.8% × $50,000 ($250,000 – $200,000), or $1,900.
NII generally includes net income from, among others, taxable interest, dividends, capital gains, rents, royalties and passive business activities. Several types of income are excluded from NII, such as wages, most nonpassive business income, retirement plan distributions and Social Security benefits. Also excluded are alimony and nontaxable gain on the sale of a personal residence.
Given the way the NII tax is calculated, you can reduce the tax either by reducing your MAGI or reducing your NII. Consider:
- Deferring income to next year or accelerating expenses into this year,
- Reducing your capital gains by selling investments at a loss,
- Decreasing your MAGI by maximizing contributions to IRAs and qualified retirement plans, or
- Investing in tax-exempt municipal bonds or in growth stocks that pay little or no dividends.
You also might be able to transfer assets that generate investment income (either directly or in trust) to lower-income family members who aren’t subject to NII tax. With this strategy, though, be careful not to inadvertently create a NII tax because of the transfer. Trusts and, for this year through 2025, individuals subject to the “kiddie tax” (generally, children under 19 or, for full-time students, 24) have a dramatically lower income threshold level at which NII tax applies.
If you own rental real estate, talk to your tax advisors about how you can avoid NII tax and obtain other tax benefits by qualifying as a materially participating “real estate professional.”
If you hold interests in pass-through entities — such as partnerships, LLCs and S corporations — it’s important to consider the interplay between NII taxes and other taxes. For instance, it may be possible to avoid NII taxes by increasing your level of participation to convert a pass-through investment from passive to nonpassive. But in some cases, doing so may also trigger self-employment (SE) or payroll taxes, so it’s important to weigh the NII tax savings against the potential SE or payroll tax costs.
Handle with care
There are many potential strategies for reducing NII taxes, but it’s important to consult with your tax advisor before you implement them. Tax reduction is an important objective, so long as it doesn’t come at the expense of prudent investment decision-making.