What is the Net Investment Income Tax (NIIT), and how can I minimize it?

The net investment income tax, or NIIT, is a 3.8% tax that applies to individuals, estates and trusts with net investment income above the applicable threshold amounts. In the case of an individual, the NIIT is 3.8% of the lesser of:

  • net investment Income, or
  • the excess of modified adjusted gross income (“MAGI”) over the following thresholds:
    • Married filing joint or qualifying surviving spouse – $250,000
    • Married filing separately – $125,000
    • Single or head of household – $200,000

The NIIT was part of Obamacare and took effect on January 1, 2013.

What is Net Investment Income?

Generally, net investment income includes the following:

  • Interest, dividend, and certain annuity distributions;
  • Rents, unless derived in a trade or business where the NIIT does not apply;
  • royalties;
  • Income from a trade or business that is a passive activity;
  • Net gains from the disposition of stocks, bonds, mutual funds, ETFs, and real estate other than property held in a trade or business to which the NIIT does not apply; and 
  • Net gains from the sale of a passive S corporation and partnership ownership interests.

What is Modified Adjusted Gross Income?

For purposes of the NIIT, MAGI is generally defined as adjusted gross income (“AGI”) for regular tax purposes increased by the foreign earned income exclusion. For individuals that have not excluded foreign earned income, MAGI is generally the same as AGI.

Strategies to Reduce Net Investment Income:

  1. Sell securities with losses before year-end to offset gains during the year from the sale of securities.
  2. Donate appreciated securities instead of cash to IRS-approved charities so that gains will not be included on your return even though you will receive a tax deduction for the donation.
  3. Use installment sales or Section 1031 like-kind exchanges to spread the gain recognition over several years or defer the gain on the property sale. These two strategies work best for investment real estate.

Strategies to Reduce Modified Adjusted Gross Income:

  1. Invest more taxable investment funds in municipal bonds. Interest income from municipal bonds is federally tax-exempt. If you are subject to the NIIT, include the 3.8% in your municipal bond interest conversion calculation when comparing taxable versus tax-exempt yields.
  2. Invest taxable investment funds in growth stocks. Gains will not be taxed until the stock is sold, and growth stocks generally do not distribute dividends.
  3. Consider conversion of traditional IRA accounts to ROTH accounts. This idea is part of a long-term strategy and requires careful coordination with your tax and investment advisors. The taxable income from the conversion will increase your MAGI and may result in more of your investment income being subject to the NIIT in the year of the ROTH conversion. However, this strategy could result in tax savings since the earnings and gains inside the ROTH will be exempt from income tax and the NIIT when distributed. 
  4. Invest in life insurance and tax-deferred annuity products. Earnings from life insurance and annuity contracts aren’t taxed until withdrawn. Life insurance death benefits are generally exempt from federal income tax.
  5. Invest in rental real estate. Rental income is offset by depreciation deductions, reducing NIIT and MAGI.
  6. Maximize deductible contributions to tax-favored retirement accounts such as 401(k) and self-employed SEP accounts to reduce your MAGI. 
  7. Consider installment sales to spread gains from selling a passive business or investment property over multiple years instead of realizing all the gains in one year.

How will I report and pay the tax if I am subject to the Net Investment Income Tax?

Individuals, estates, and trusts use Form 8960 to compute their Net Investment Income Tax (NIIT). The NIIT is reported on Form 1040 for individuals and Form 1041 for estates and trusts, and it must be considered when determining the amount of quarterly estimated tax payments that must be paid during the year.

While there are planning options to limit the impact of the NIIT, there may not be a way to avoid it if it applies. The NIIT is complex, and all strategies to minimize it should be discussed with your tax and investment advisors before implementation to prevent other unintended consequences.