This week, we will focus on an overlooked (and when not overlooked, misunderstood) part of US Federal Income Tax namely, the Net Investment Income Tax (NIIT) and how the IRS could apply it to you. Other common terms used for this federal tax which might be more familiar to you are: NIIT Tax or Investment Income Tax.
The purpose of this article is to explain in a simplified manner the complex topic of Net Investment Income Tax to the reader.
WHAT IS NET INVESTMENT INCOME (NII)?
In summary, NII is income derived from investment assets (before any applicable taxes are applied) such as bonds, stocks, mutual funds, annuities, loans, and other investments (less properly allocable expenses).
WHAT IS THE NET INVESTMENT INCOME TAX (NIIT)?
NIIT is a surtax imposed on certain unearned income. The tax equals 3.8% of the lesser of the taxpayer’s NIIT, or the excess of the taxpayer’s modified gross income (MAGI) over a threshold.
It applies to estates, trusts, families and individuals, however certain income thresholds need to be met before the tax takes effect.
HOW THE NET INVESTMENT INCOME TAX DEVELOPED
The main purpose for including NIIT as part of that legislation was to raise revenue. The official name of the NIIT is actually “Unearned Income Medicare Contribution Tax” which logically would imply that it is used to fund Medicare which is not the case.
HOW NET INVESTMENT INCOME TAX WORKS
In the case of an individual, section 1411(a)(1) 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% 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.
Section 1411(b) provides that the threshold amounts for individuals’ filing status are as follows –
– in the case of an individual making a joint return or a surviving spouse $250,000 (married filing);
– in the case of a married taxpayer filing a separate return (not married filing), $125,000; and
– in the case of any other individual, $200,000 including head of household. (In order to qualify as a head of household certain criteria needs to be met by the taxpayer).
In the case of a trust or an estate, section 1411(a)(2) imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal a tax rate of 3.8% of the lesser of the trust’s or estate’s undistributed net investment income, or the excess (if any) of the trust’s or estate’s adjusted gross income (AGI) for such taxable year, over the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year.
WHEN DID THE NET INVESTMENT INCOME TAX TAKE EFFECT?
In the 2012 tax year, Congress passed a Medicare surtax on investment income at a tax rate of 3.8% as part of the Health Care and Education Reconciliation Act of 2010 to help pay for the Affordable Care Act. This surtax was effective for tax years beginning after December 31, 2012.
WHAT COUNTS AS NET INVESTMENT INCOME?
It is important to understand what types of investment income is included in NII and what type of investment income is excluded.
|Net Investment Income Includes:||It Doesn’t Include:|
|Short and long-term Capital gains.
Rental and royalty income.
Qualified and nonqualified dividends.
Passive income from investments which are not actively participated in.
Business income from trading financial instruments or commodities.
Taxable portion of nonqualified annuity payments. (for example Roth IRAs)
Veterans’ or Social Security benefits.
Qualified retirement plan withdrawals.
Pay-outs from a deferred compensation plan from a state, local government or tax-exempt organization.
Pay-outs from a traditional defined benefit pension plan or retirement annuity.
Proceeds from life insurance
Income from a business which is actively participated in.
Tax-exempt interest from municipal bonds or funds.
Tax-exempt income/capital gains from the sale of your primary residence.
HOW TO PAY THE NET INVESTMENT INCOME TAX
If you are subject to NIIT, you will need to file IRS Form 8960 with your tax return. The form has detailed instructions to assist you with determining your NIIT liability and will depend on your filing status. (i.e., head of household, married filing etc.). The form is used for individuals, trusts and estates when submitting tax returns.
WHERE DOES THE TAX REVENUE GO?
The amounts collected under the NIIT are not designated for the Medicare Trust Fund. The revenues raised by this tax goes into the nation’s general fund.
WHAT INDIVIDUALS ARE SUBJECT TO THE NET INVESTMENT INCOME TAX?
All individuals who file tax returns, except Non-resident Aliens (NRAs), are subject to NIIT if they have NII and MAGI over the above-mentioned taxable income thresholds.
WHAT ESTATES AND TRUSTS ARE SUBJECT TO THE NET INVESTMENT INCOME TAX?
Trusts and Estates that have Undistributed Net Investment Income and an AGI more than the highest tax bracket applicable will be subject to the NIIT.
Special computational rules apply for certain unique types of trusts set up for a small business, such as an electing small business trust (ESBT) which can be found in the final regulations.
HOW TO CALCULATE THE NIIT?
Earlier we stated that the NIIT liability is based on the lesser of your NII or the amount by which your MAGI surpass the filing status-based thresholds imposed by the IRS.
Calculating MAGI: For purposes of NII, MAGI 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 adjusted gross income are listed on Schedules 1, 2, and 3 to Form 1040. If your MAGI is higher than the thresholds for your filing status, you will need to pay NIIT.
Calculating Net Investment Income: The next step is to calculate your NII based on the included income stated above. Before you can calculate your NII, you first need to ascertain what your gross investment income is. This is the amount prior to considering any eligible deductions.
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.
Calculating Net Investment Income Tax:
The amount that will be subject to NIIT at a rate of 3.8% 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.
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, hence why it is important to get advice from a CPA or relevant professional.
ADDITIONAL QUESTIONS AND ANSWERS ON THE NIIT
1. What Is Modified Adjusted Gross Income For Purposes Of The Net Investment Income Tax?
Answer: In simple terms, MAGI = Adjusted Gross Income (AGI) + certain adjusted foreign earned income exclusions.
2. What Is Included In Net Investment Income?
Answer: In general, investment income includes, but is not limited to:
– capital gains,
– rental and royalty income,
– non-qualified annuities,
– income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities.
To calculate your NII, your investment income is reduced by certain expenses properly allocable to the income.
3. What Are Some Common Types Of Income That Are Not Net Investment Income?
Answer: In general, NII does not include the following:
– unemployment compensation;
– operating business income from a non-passive activity,
– Social Security Benefits,
– tax-exempt interest,
– self-employment income,
– 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)) such as qualified annuities.
4. What Kinds Of Gains Are Included In Net Investment Income?
Answer: In general, the following capital gains are common examples of items taken into account in computing NII.
– gains from the sale of stocks, bonds, and mutual funds.
– capital gains distributions from mutual funds.
– gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence).
– gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner).
5. Does This Tax Apply To Gain On The Sale Of A Personal Residence?
Answer: Section 121 exempts the first $250,000 ($500,000 in the case of a married couple) of gain recognized on the sale of a principal residence from gross income for regular income tax purposes and, thus, from the NIIT.
6. Does Net Investment Income Include Interest, Dividends And Capital Gains Of My Children That I Report On My Form 1040 Using Form 8814?
Answer: Yes. The calculation, however, does exclude certain amounts.
7. What Investment Expenses Are Deductible In Computing NII?
Answer: Some examples of deductions which may be properly allocable to gross investment income include the following –
– brokerage fees;
– investment advisory fees;
– tax preparation fees;
– fiduciary expenses which will only apply to estates and trusts;
– interest expenses;
– investment advisory fees;
– expenses incurred in relation to royalty and rental income; and
– state and local income taxes.
If the deductions aren’t properly allocable to gross investment income, it will not be allowed as a deduction. For instance, brokerage fees that are not properly allocable will not be allowed as a deduction. The instructions to Form 8960 provides examples of deductions that are not deductible for NII purposes. For example, deductions for contributions to IRAs or other qualified plans.
Special rules apply for traders in financial instruments and commodities regarding the deduction of expenses in relation to self-employment income.
8. Will I Have To Pay Both The 3.8% Net Investment Income Tax And The Additional .9% Medicare Tax?
Answer: You may be subject to both taxes, but not on the same type of income. These two taxes apply to different types of income.
9. If I Am Subject To The Net Investment Income Tax, How Will I Report And Pay The Tax?
Answer: For individual taxpayers, the NIIT will be reported on and paid with Form 1040 and for estate and trust taxpayers with Form 1041 All taxpayers will however use Form 8960 to compute their NIIT.
10. Is The Net Investment Income Tax Subject To The Estimated Tax Provisions?
Answer: Yes. It is also subject to estimated tax provisions. Taxpayers that expect to be subject to NIIT should ensure that their income tax withholding or estimated payments are adjusted to account for this tax.
11. Can Tax Credits Reduce My NIIT Liability?
Answer: Yes. Any tax credit that is allowed to offset a tax liability imposed by subtitle A of the Code may be used to offset the NII. If the tax credit is only allowed to be offset against tax imposed by Chapter 1 of the Code, such as regular income tax, that credit may not reduce the NIIT.
12. Does The Tax Have To Be Withheld From Wages?
Answer: There is no obligation that the tax should be withheld for wages, however you may request that additional income tax be withheld from your wages for this purpose