How to Avoid the Net Investment Income Tax

Ever since the net investment income tax, or NIIT, was introduced by the IRS, taxpayers have tried to understand this tax and at the same time try to avoid it. What follows is an introduction of what this tax entails, how it is triggered, the types of income that are and are not included, how to calculate it and, strategies for how to avoid or minimize it. 

What Is The Net Investment Income Tax?

This is a tax that is not widely understood by many people, but is a very important concept to learn about, especially if a large part of one’s income is derived from investments. 

Simply put, the NIIT is a 3.8 percent tax that is applied on certain investment income. For the purposes of calculating net investment income (NII), the IRS looks at income derived from investments (before any applicable taxes are applied) such as bonds, stocks, mutual funds, annuities, and loans (minus properly allocable expenses). 

The other way to think about this tax is that it is a surtax imposed on certain unearned income. The tax equals 3.8 percent of the lesser of the taxpayer’s NIIT, or the excess of the taxpayer’s modified gross income (MAGI) over a certain threshold (discussed later in this article). 

The tax applies to estates, trusts, families and individuals. However, certain income thresholds need to be met before the tax takes effect. 

When Did The Net Investment Income Tax Take Effect?

As is the case with all taxes, the main purpose for including NIIT as part of the Health Care and Education Reconciliation Act, was to raise revenue. In this case, this surtax was used to help pay for the Affordable Care Act. The official name of this tax is actually “Unearned Income Medicare Contribution Tax,” which would logically imply that it is used to fund Medicare. However, this is not the case. The surtax is effective for tax years beginning after December 31, 2012.

What Triggers Net Investment Income Tax?

In the case of individual taxpayers, section 1411(a)(1) of the tax code imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to a tax rate of 3.8 percent of the lesser of the individual’s NII for that tax year, or the excess (if any) of the individual’s MAGI for that tax year, over the threshold amount. We will discuss the calculations behind this tax, later in this article.

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What Counts As Net Investment Income?

Net Investment Income Includes:

For the purposes of calculating this tax, net investment income includes short and long-term capital gains (as well as gains from the sale of investment real estate, and gains from the sale of interests in partnerships and S corporations to the extent the partner or shareholder was a passive owner), taxable interest income, rental and royalty income, qualified and non-qualified dividends, passive income from investments, business income from trading financial instruments or commodities, and taxable portion of non-qualified annuity payments (for example, Roth IRAs). 

It Doesn’t Include:

In general, NII does not include wages, unemployment income, operating business income from a non-passive activity, Social Security Benefits, alimony, tax-exempt interest, self-employment income, municipal bonds, Alaska Permanent Fund Dividends and distributions from certain qualified plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b) of the tax code), such as qualified annuities.

What Is Exempt From NIIT?

The NIIT does not apply to any portion of a gain that is excluded from regular income tax. Therefore, gains from sale of a principal residence are excluded from the NIIT unless the gain exceeds the principal residence exclusion amount of $250,000 (for a single filer) or $500,000 (if filing jointly with your spouse).

In addition, non-resident aliens (NRAs), who are individuals that are neither U.S. citizens nor U.S. residents, are not subject to this tax. The U.S. Treasury regulations state that in the case of a U.S. citizen or resident who is married to a non-resident alien individual, the spouses will be treated as married filing separately for purposes of section 1411. The U.S. citizen or resident spouse will be subject to the threshold amount for a married taxpayer filing a separate return, and the non-resident alien spouse will not be subject to the NIIT.

Who’s Subject To The Net Investment Income Tax?

All individuals who file tax returns, except NRAs, are subject to NIIT if they have NII and MAGI over the aforementioned taxable income thresholds. 

Trusts and estates that have undistributed NII and an AGI greater than the highest tax bracket applicable will be subject to this tax. 

Is Your MAGI Greater Than The Threshold?

For the purposes of meeting the threshold to be subject to this tax, the MAGI amounts are:

  • Married filing jointly — $250,000
  • Married filing separately — $125,000
  • Single or head of household — $200,000 or
  • Qualifying widow(er) with a child — $250,000

How To Calculate The NIIT?

The tax itself is computed on Form 8960 of one’s U.S. tax return. Individual filers report and pay the tax on Form 1040, while trusts and estates report and pay this tax on Form 1041. 

For purposes of calculating NII, modified adjusted gross income is a household’s AGI, with certain deductions and tax-exempt interest payments, such as contributions from individual retirement accounts (IRAs), included again. The relevant deductions for purposes of AGI are listed on Schedules 1, 2, and 3 of Form 1040. If your MAGI is higher than the thresholds for your filing status, you will need to pay NIIT.

The next step is to calculate your NII based on the included income stated above. Before you can calculate your NII, however, you first need to ascertain what your gross investment income is. This is the amount prior to considering any eligible deductions (which are discussed later in this article). 

Once you arrive at the gross investment income, it will be reduced by deductions allowed against the income tax which are properly allocable to those items of gross income or net gain to arrive at the NII. 

Finally, the amount that will be subject to NIIT at a rate of 3.8 percent will therefore vary as follows: 

  • If your NII is higher than the amount by which MAGI surpasses the threshold, the tax applies to your MAGI
  • If your NII is lower than the amount by which MAGI surpasses the threshold, the tax applies to your NII

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Will I Have To Pay Both The 3.8% Net Investment Income Tax And The Additional .9% Medicare Tax?

You may be subject to both taxes, but not on the same type of income, as these two taxes apply to different types of income. The 0.9 percent additional Medicare tax applies to individuals’ wages, compensation, and self-employment income over certain thresholds, but it does not apply to income items included in NII.

Can Tax Credits Reduce My NIIT Liability?

Indeed, any tax credit that is allowed to offset a tax liability imposed by subtitle A of the tax code may be used to offset the NII. However, if the tax credit is only allowed to be offset against tax imposed by Chapter 1 of the tax code, such as regular income tax, that credit may not reduce the NIIT. For instance, foreign tax credits may not be used to reduce NIIT exposure in the U.S., as they are only allowed to offset a tax liability on regular income tax. Further, foreign tax credits are only allowed against taxes imposed by IRC Chapter 1. 

Strategies To Avoid Or Reduce The Tax

There are various strategies and planning opportunities to either reduce your NII or reduce your MAGI, which will result in reduced taxable income. No blanket strategy or planning tool exists, and due to the complex nature of the NIIT, it is advisable to consult professionals such as your tax advisor or CPA on possible mitigation. The IRS will not be lenient if these regulations are willfully avoided. This is why it is so important to get advice from a tax advisor who has experience dealing with these sorts of matters.

Tips For Managing Your Investments

As stated previously, no blanket strategy or planning tool exists, due to the complex nature of this tax. However, if you do have investment income and if you think you will be subject to this tax, there may be deductions available for you to take advantage of.

Some examples of deductions which may be properly allocable to gross investment income include brokerage fees, investment advisory fees, tax preparation fees, fiduciary expenses (which only apply to estates and trusts), interest expense, investment advisory fees, expenses incurred in relation to royalty and rental income, and state and local income taxes. 

If the deductions are not properly allocable to gross investment income, then they will not be allowed. For instance, brokerage fees that are not properly allocable will not be allowed as a deduction. The instructions to Form 8960 provide examples of deductions that are not deductible for NII purposes; for example, deductions for contributions to IRAs or other qualified plans. 

Additionally, special rules apply for traders of financial instruments and commodities regarding the deduction of expenses in relation to self-employment income.


If you have further questions or want to begin the process, reach out to one of our Asena consultants.

Arin Vahanian

Peter Harper