Net Investment Income Tax: How Does It Affect You?

Editor: Mark G. Cook, CPA, MBA, CGMA

The net investment income tax imposed by Sec. 1411 is a 3.8% tax on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount, which is discussed later. Under Sec. 1411(d), MAGI is defined as adjusted gross income increased by the amount excluded from gross income under Sec. 911(a)(1) (the foreign earned income exclusion) over the amount of deductions or exclusions disallowed under Sec. 911(d)(6) (denial of a double tax benefit from excluded foreign earned income). The net investment income tax went into effect for tax years beginning on or after Jan. 1, 2013, and is more likely to affect wealthier individuals, but can also affect individuals of more moderate means who have a spike in income in a particular year.

Investment income for purposes of the net investment income tax includes:

• Annuity distributions;
• Dividends;
• Income from passive activities;
• Interest and net gain, to the extent taken into account in computing taxable income, from the disposition of property other than property held in a trade or business to which the net investment income tax does not apply;
• Rents; and
• Royalties.

Income such as salaries and wages, IRA distributions, self-employment income, gain on sale of an active interest in a partnership or S corporation, capital gains from the sale of a principal residence excluded under Sec. 121, tax-exempt interest, and veterans benefits are excluded.

As noted above, the net investment income tax applies to an individual taxpayer only when the taxpayer’s MAGI exceeds a threshold amount. The thresholds for each type of affected taxpayer are as follows:

• Single: $200,000;
• Married filing jointly: $250,000; and
• Married filing separately: $125,000.

Other Ways to Minimize Net Investment Income Tax

Taxpayers can avoid the net investment income tax by avoiding income that is subject to the tax and by keeping their MAGI below the applicable threshold amount. Ways to achieve these goals include:

Roth IRA conversions: Withdrawals from Roth IRAs, unlike withdrawals from traditional IRAs and qualified plans, are not includible in MAGI for purposes of the net investment income tax, so a withdrawal from a Roth IRA will not cause other income to be subject to the tax. However, the deemed distribution in the year of conversion is included in MAGI, so a taxpayer may want to do conversions over a number of years to avoid having the conversion trigger the tax.

Installment sales: Deferring gains by spreading the proceeds through installments will defer application of the 3.8% tax on the gains or possibly avoid the tax by keeping MAGI under the threshold in any year.

Charitable contributions: By donating appreciated securities held more than one year to approved charities, taxpayers may avoid tax on any related gains while still benefiting from the deduction.

Municipal bonds: These will reduce both net investment income tax and MAGI.

Tax–deferred annuities: Earnings from this type of annuity are not taxed until withdrawn.

Life insurance: Paid-out death benefits are generally exempt from the 3.8% tax because they are excluded from gross income.

Rental real estate: Income can be offset by depreciation deductions.

Oil and gas investments: Income from oil and gas investments can be offset by deductions for intangible drilling costs and depletion.

The net investment income tax, targeted primarily toward the wealthy, is an additional tax on top of regular tax liability. Fortunately, proper planning and the assistance of a tax professional may allow this tax to be deferred, reduced, or, in some cases, avoided completely.

EditorNotes

Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.