What is the net investment income tax and who has to pay it?

If your investments made money, you might owe something called the net investment income tax (NIIT) on your profits. Although many investors are not likely to get hit with this bill, it’s important to know whether or not you’re subject to the NIIT to avoid any surprises when it comes time to file your taxes.

What is the net investment income tax?

NIIT is a tax on net investment income. Those who are subject to the tax will pay 3.8 percent on the lesser of the following: their net investment income or the amount by which their modified adjusted gross income (MAGI) extends beyond their specific income threshold.

Net investment income typically includes the following:

• interest
• dividends
• capital gains
• income from rental properties
• royalties
• non-qualified annuities (the taxable portion of the investments)
• passive investment income
• business income from financial trading (this is earned income if it is from your job)

Qualified annuities can be part of a retirement plan or IRA, and thus subject to different tax laws. Non-qualified annuities, such as those that are personally owned (as one would personally own a brokerage account, for example,) fall under the umbrella of net investment income.

These are the broader examples of what falls under net investment income – but estates and trusts, for example, can also be subject to the tax depending on certain rules and how they are titled. The IRS details exactly what qualifies as net investment income. It’s important to note that “net income” means once losses are deducted from the investment.

There are several other types of income the IRS states do not count toward the NIIT:

• wages
• unemployment compensation
• alimony payments
• most self-employment income
• Social Security benefits
• qualified plan withdrawals (401(k), IRA, etc.)
• money received from traditional defined pensions or retirement plan annuities
• life insurance proceeds
• proceeds from state/local government or other tax-exempt organizations
• active business investment income

Who is subject to paying NIIT?

Not everyone will need to pay the NIIT, and only those above certain income thresholds will be subject to it. The IRS statutory income thresholds are as follows:

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

Those who exceed the income thresholds based on their filing status have to determine whether their net investment income or the amount by which their MAGI exceeds the threshold is larger. The lower number of the two is the one that will be subject to the 3.8 percent additional tax. The income thresholds are not indexed for inflation.

How NIIT is calculated

Here’s an example of how to calculate NIIT.

Kelly and John are married and file jointly, and their MAGI is $500,000, exceeding their filing status threshold by $250,000. They will certainly be subject to the NIIT if they have net investment income. After all gains and losses are calculated for the year, their net investment income comes out to $100,000. So they will be subject to the 3.8 percent NIIT on the $100,000, as it is the lesser of the two numbers. Kelly and John would need to pay $3,800 in NIIT, or $100,000 x 0.038 = $3,800.

Had their net investment income been $300,000, then Kelly and John would pay 3.8 percent on the $250,000 by which their MAGI exceeds the income thresholds. Here, Kelly and John would pay $9,500 in NIIT tax, or $250,000 x 0.038 = $9,500.

How to avoid the NIIT

If you’re worried you might be subject to the extra tax, you have several ways to offset net income. The best thing to do is speak to a licensed accounting professional who can assist in making sure whatever you offset is IRS-friendly.

Here are some additional tips for avoiding the NIT:

• Reduce your taxable income: You can do this by contributing to tax-advantaged retirement plans such as a 401(k), 403(b), traditional IRA or SEP IRA. Contributions to these pre-tax accounts reduce your overall taxable income. However, after-tax accounts, like Roth IRAs, won’t help reduce your taxable income.
• Offsetting investment losses against investment gains: You can use your losing investments to reduce the taxable amount of your winning investments through a process known as tax-loss harvesting.
• Increase the amount you claim for certain investment expenses: These expenses can include deductions for rental property upkeep or maintenance, trading fees and even state taxes. Property taxes on investment properties might even pass as a way to offset net investment income.
• Plan ahead: Even if you can’t lower taxable income this year, work with a CPA to identify financial strategies and other deductions to minimize NIIT next year.

FAQs

• If I’m subject to the NIIT, how do I report and pay it?

  If you owe the NIIT, you’ll report it on IRS Form 8960 and attach it to your tax return (Form 1040). The tax is calculated based on your net investment income and modified adjusted gross income (MAGI). You may need to make estimated tax payments throughout the year to avoid underpayment penalties. Speak with a tax professional to ensure accurate reporting and compliance.

• How can you avoid the net investment income tax?

  To reduce or avoid NIIT, consider lowering your taxable income by contributing to tax-advantaged accounts like a 401(k) or traditional IRA. Tax-loss harvesting — offsetting investment gains with losses — can also help. Another strategy is deducting eligible investment expenses and structuring income to fall below the NIIT threshold.

• Can tax credits reduce my NIIT liability?

  No, tax credits do not reduce NIIT because it is separate from regular income tax. The NIIT is based solely on your net investment income and MAGI, with no direct offsets from credits like the child tax credit or foreign tax credit.

• What investment expenses are deductible in computing NII?

  Certain expenses can be deducted when calculating net investment income (NII), including investment advisory fees, trading commissions, rental property expenses, and state or local taxes related to investments. Expenses must be directly tied to generating investment income and cannot be deducted if they are already excluded under other tax rules.

Bottom line 

The net investment income tax adds an extra 3.8 percent tax on investment income for high earners, but with the right strategies, you can reduce or eliminate it. Contributing to tax-advantaged accounts, tax-loss harvesting and deducting eligible investment expenses can help lower your taxable income. If you think you may owe NIIT, working with a CPA or a financial advisor can help you stay compliant while minimizing your tax bill.

— Bankrate’s Rachel Christian contributed to an update of this article.