The net investment income tax is a 3.8% surtax on a percentage of your MAGI that exceeds specific levels. High-income earners typically pay it with substantial investment income.
Even if you use deductions, credits, and other tax breaks to avoid paying considerable income taxes on your investment income, the net investment income tax may still apply to your finances.
This article will explain what net investment income tax is, how it works and who is responsible for paying it.
What Is Investment Income?
Investment income includes interest payments, dividends, capital gains earned from the sale of shares or other assets, and any additional profit made via the use of an investment vehicle.
It includes interest gained on bank accounts, dividends got from stock owned through mutual fund holdings and profits from the selling of gold coins.
Income from long-term investments is taxed differently and frequently preferentially depending on the country and area.
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Understanding Investment Earnings
The term “investment income” refers primarily to financial gains over the initial cost of the investment.
The type of the income, such as interest or dividend payments, is unimportant in determining whether it is deemed investment income, as long as it is earned from a previous investment.
Furthermore, investment income can be obtained as a single payment or as recurring interest instalments paid out.
Most people generate most of their net income each year through regular employment income.
Disciplined saving and investing in financial markets can turn modest savings into huge investment portfolios, delivering an individual a sizable annual investment income.
Investments are a common source of revenue for businesses. They typically show an item called investment income or losses on the financial statements of publicly traded firms.
This is where the company declares the portion of its net income that was achieved through investments made with extra funds rather than through its normal line of business.
For a company, this might include all the above, as well as the interest gained or lost on its bonds, share buybacks, corporate spinoffs, and acquisitions.
Interest earned on a basic savings account is regarded as investment income. The interest is earned besides the initial investments, which are the deposits made into the account. As a result, the account is a source of revenue.
Options, equities, and bonds can also generate investment income. Whether through recurring interest or dividend payments or by selling an asset at a greater price than paid for it, cash received over the investment’s original cost stand as investment income.
What is Net Investment Income?
Net investment income (NII) is the income earned from investment assets such as bonds, equities, mutual funds, loans, and other investments before taxes (less related expenses).
Individual tax rates on net investment income vary depending on whether the income is interest, dividends, or capital gains.
Understanding Net Investment Income (NII)
When investors sell assets from their portfolios, the transaction proceeds result in either a realized gain or loss.
Capital gains from the sale of stock; interest income from fixed income products; dividends paid to firm shareholders; rental income from property; some annuity payments; royalty payments, and so on are examples of realized gains.
The net investment income is the difference between any realized gains (before taxes) and any trade commissions or fees (NII).
Depending on whether the asset was sold for a capital gain or loss, NII could be positive or negative.
What is Net Investment Income Tax?
The net investment income tax (NIIT) is a 3.8% tax on investment income that usually only applies to high-income people. Individuals, families, estates, and trusts are all subject to the tax, although certain income levels must be fulfilled before the tax becomes effective.
Capital gains, interest, and dividends are all examples of net investment income. It can include rental income, capital gain dividends from mutual funds, royalty or annuity income, and interest on loans you may have made to others.
It comprises passive revenue from trade and income from a business selling financial instruments or commodities.
History of the Net Investment Income Tax
As part of the Health Care and Education Reconciliation Act of 2010, the net investment income tax was enacted.
It becomes effective on January 1, 2013. This Act, together with the Affordable Care Act, altered the healthcare market by mandating individuals to buy health insurance or face a tax penalty.
To generate revenue, it inserted the net investment income tax in the Act. The Joint Committee on Taxation expected that the net investment income tax, when combined with the Additional Medicare Tax, would raise billions of dollars in tax revenue in 2013, the first year that this surtax would be in force.
Officially, you can also call the net investment income tax ‘Unearned Income Medicare Contribution Tax’.
This implies that the tax revenue is used to support Medicare, but the tax revenue is used to fund the nation’s general fund.
In reality, because these two taxes apply to distinct sorts of income, you may be subject to the net investment income tax even if you are exempt from the Additional Medicare tax.
How does the Net Investment Income Tax Work?
When a taxpayer sells almost any sort of investment, they will either experience a gain or a loss such that, they will make money if they sell for less than what they invested in the asset or they will lose money if they sell for less than what they put in the item.
There are, however, some exceptions. Net investment income does not include tax-free interest. Gains from the sale of a personal residence are also exempt where the gain is deducted from income for income tax purposes.
Gains on property held in trade are likewise exempted.
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How do I Manage Net Investment Income Tax?
Just because you make a lot of money and have a lot of investment income doesn’t imply you have to pay a lot of NIIT.
You can manage your net investment income tax burden by reducing the amount of net investment income reported as well as your modified adjusted gross income.
Chris Schiffer of the Wealth Enhancement Group in Basking Ridge, N.J., advises, however, that “the tax tail should not wag the investing dog.”
But if you’re in charge of the leash, here’s what you can do.
#1. Capital Gains Should Be Timed
If possible, Schiffer advises paying close attention to the timing of capital gains recognition. You may time the selling of stocks that have had major profits with the sale of those that have experienced significant losses.
This is a practice known as tax-loss harvesting, and it can help you reduce your net income.
If your income varies greatly from year to year, you may be able to schedule the sale of your securities for years when your MAGI is less than the NIIT requirement, according to Schiffer.
#2. Make Use Of Charitable Contributions
However, if you cannot postpone realizing your advantages, you are not without options. Charitable contributions may allow you to minimize your net investment income.
If you’re already going to make charitable contributions, consider if you may substitute cash donations for donations of appreciated securities.
This way, you won’t have to report again on your tax return and you’ll still be able to take advantage of the tax deduction from the charitable gift.
In addition, to limit NIIT’s obligation, you may want to consider establishing a charitable remainder trust (CRT). “A CRT is an irrevocable, tax-exempt trust in which the grantor deposits assets to pay income over a specified period.”
“CRTs are excluded from Clause 1411 [the tax code section that pertains to the NIIT], which means that gains sold by the CRT are not subject to the net investment income tax,” Schiffer adds.
#3. Adjust Your Magi
If none of those approaches works for you, calculate your changed adjusted gross income instead. If you rely on fixed-income investments, municipal bonds should be considered over other bond kinds.
These instruments are exempt from federal taxation and, in most cases, from state income tax if they are issued in the state where the taxpayer resides.
Growth stocks, which normally do not pay dividends and will not affect your MAGI until you sell them and realize gains, are another investment that can assist reduce MAGI.
Whole-life policies that grow cash value and tax-deferred annuities do not produce taxable income until they are withdrawn.
Importantly, seek to contribute as much as possible to tax-advantaged retirement vehicles such as 401(k) and SEP plans. Donations to these accounts, unlike IRA contributions, reduce your MAGI.
How Do I Pay the Net Investment Income Tax?
If you are subject to the net investment income tax, include IRS Form 8960 with your tax return. The form includes instructions to assist you to figure out how much you owe, and both people and estates or trusts may use it.
Remember that if you owe this tax, you must make quarterly estimated payments on the amount you believe you will owe beside any quarterly income payments.
How to Calculate Net Investment Income Tax
The net investment income tax is a 3.8% surtax added to regular income taxes. However, not everyone who earns a living from their investments is affected. It only applies to incomes above the aforementioned criteria.
In practice, this means that you’ll need your changed adjusted gross income (MAGI) beside your net investment income to calculate your NIIT. Here’s how to figure out both.
How to Determine Net Investment Income
Net investment income is calculated by aggregating all of your investment revenue from the previous tax year and subtracting any related expenses.
Profits realized while selling investments, dividend and interest payments received, and income from rental properties are all examples of investment income as defined by the IRS.
Commissions and tax preparation costs are examples of related charges.
Modified Adjusted Gross Income Calculation (MAGI)
MAGI is a household’s adjusted gross income after tax-exempt interest payments and certain deductions, such as student loan interest payments and IRA contributions, are deducted.
Line 11 of the 2020 Form 1040 contains your adjusted gross income. Deductions such as student loan interest payments, tuition expenses, IRA contributions, taxable Social Security payments, the deduction for self-employment taxes, and rental losses must then be subtracted.
Deductions that apply will be shown on Schedules 1, 2, and 3 of Form 1040.
Calculating Net Investment Income Tax
Now that we have the components, let us compute NIIT. If your MAGI exceeds the above criteria, you will almost certainly be subject to net investment income tax and will need to calculate NIIT on Form 8960.
It is not as straightforward as multiplying your net investment profits by 3.8% to calculate NIIT. You get a pass from the IRS.
You are charged 3.8 percent of net investment income or the amount by which your MAGI exceeds the income thresholds required to incur NIITs.
For example, if you were a single filer earning $250,000 and $25,000 of that was net investment income, your NIIT would be calculated solely on the income from your investments.
This is because $25,000 is less than $50,000—the difference between the $200,000 and $250,000. The cost of your NIIT would then be $950.
If you made $75,000 in net investment income but had the same MAGI, your NIIT would be calculated based on the $50,000 you earned above the cutoff. Your NIIT would be $1,900 in that situation.
MAGI is the same as AGI for the vast majority of taxpayers. This is because the only adjustments required to AGI to arrive at MAGI are for overseas earned income.
Any taxpayer with net investment income (of any amount) and modified adjusted gross income (MAGI) over $200,000 for single filers, $125,000 for married filers filing separately, and $250,000 for married couples filing jointly.
No, but you can request that additional income tax be withheld from your paycheck.
A capital gain occurs when you profit from the sale of investments. Furthermore, you must pay a capital gains tax on the capital gain. Some people who owe capital gains tax also owe NII tax.
You must pay taxes on everything, whether you are a business owner or an individual taxpayer (including tax on investment income).
However, the type of tax you pay is determined by how you earn the money. As a result, this tax only applies in limited circumstances.