The net investment income tax (NIIT), albeit sounding very similar to the capital gains tax, is actually a different kind of investment tax that only applies to high net worth individuals, as well as certain kinds of estate and trust accounts.
In this article, we are going to look at how an individual can know whether or not they must pay the net investment income tax, and we will also provide an explanation of how to calculate the expected tax burden resulting from this kind of tax.
General Information About the Net Investment Income Tax
Also known as the Medicare Surcharge Tax, the net investment income tax appeared as an additional tax on individuals who either made a large amount of money in salary or realized a very large capital gain during the fiscal tax year. In many cases, it applies to a crossover of both situations.
The tax is 3.8% on an annual modified adjusted gross income (MAGI) over $200,000 for individuals, $250k for married couples filing jointly, and $125k for married individuals filing separately. For the purposes of this article, we will only address how the tax pertains to individuals.
Top 7 Tips on How to Calculate and Pay Your Net Investment Income Tax
Tip 1: Know How to Calculate Your MAGI
In order to know whether or not you need to pay the NIIT tax, you will need to know how to calculate your modified adjusted gross income. Currently, you can calculate this as:
Yearly Salary + Capital Gains - Tax Deductions - Tax Credits = MAGI
For example, an individual making $50k could take the standard deduction which is currently $6,300 and have a MAGI of $42,700. That $42,700 would be the amount that is taxable, while the full $50k would NOT be taxable income.
Tip 2: See If Your MAGI Meets the IRS Threshold Limits for the NIIT
It is possible that the income limits for the net investment income tax may change in the coming years since the tax code is always evolving. As a result, check the IRS website dealing with the NIIT tax each year to see if your MAGI exceeds the threshold that then requires you to pay the NIIT tax.
If it does, you will need to pay 3.8% on any amount that exceeds the limit that comes from investment income.
Tip 3: How to Actually Calculate Your NIIT Liability
Remember, the net investment income tax applies only to investment gains in cases where high income is present. For example, a gentleman who makes $175k per year in salary and who made $75k in investment income would have to pay the 3.8% tax on $50,000.
Why is this? Well, since the individual made more than $200,000 in MAGI during the previous year which is the threshold for individual earners for the NIIT, he owes the net investment income tax on any investment gains above $200,000.
$250k (what the individual made last year as income and investment)- $200k (threshold)=$50,000.
The tax he would have to pay, then, is $50,000*3.8% = $1,900.
Tip 4: How to Pay the Net Investment Income Tax
Most tax accounting software in existence these days will be able to automatically determine whether or not you must pay the net investment income tax, as well as how much you will be required to pay.
Once you determine that, you are able to pay either through the tax software channels themselves. On the other hand, you can even opt to pay your taxes through the IRS tax payment website.
Tip 5: How to Avoid or Reduce the NIIT
There are usually ways to avoid or reduce the net investment income tax targeted at reducing modified adjusted gross income for the tax year. You could do this on their dedicated web page.
- Taking more deductions: There are all sorts of tax deductions out there that taxpayers should know about. In fact, the IRS has created a web page that has every tax deduction and credit currently in existence for your planning purposes.
- Reducing yearly income: If you are self-employed and you have the potential to cross the threshold for paying the NIIT, it may be worth keeping more of your income in accounts/receivable until the year ends.
- Finding new tax credits: The government often incentivizes certain kinds of investments with tax credits to encourage that kind of investing. Look for these to offset investment gains.
Tip 6: The NIIT May Not Exist Much Longer; Plan Accordingly
Political viewpoints aside, it is prudent to mention that the net investment income tax is purportedly going to be eliminated with the initiation of the current administration’s tax plan later this year.
As a result, it may be wise to employ methods to lessen investment income this year in an effort to realize more investment income next year that the NIIT will not tax. Of course, such a strategy would require the counsel of a good tax advisor, financial planner, and accountant.
Tip 7: Real Estate Can Hedge in the Mean Time
Real estate is a great investment class for a variety of reasons. However, it is probably the best investment class for avoiding having to pay the NIIT. This is because purchased real estate can be depreciated, thereby reducing taxable income greatly.
If it is possible, try to purchase rental real estate properties or “fixer-uppers.” Then, you could use the depreciation from these properties to entirely avoid, or greatly reduce, your NIIT potential while the tax is still in place.
Putting It All Together
So, the net investment income tax is a tax that one will only need to pay by high-net-worth or high capital gains accruing individuals. In many cases, one can avoid it entirely with good investment planning. Take the proper steps throughout the year to manage your tax liabilities. This way, you stand a good chance of never having to face the net investment income tax.