The Net Investment Income Tax Explained

High earners with investment income may face an additional tax beyond regular income taxes and capital gains taxes: the net investment income tax. Because it’s an extra layer of tax that applies only above certain income levels, many people don’t realize it affects them until they prepare their tax return. Understanding how it works can help you plan and potentially reduce it.

What the net investment income tax is

The net investment income tax, often abbreviated NIIT, is a 3.8% federal tax that took effect in 2013. It was enacted as part of health care legislation and applies to certain investment income for individuals, estates and trusts with income above specific thresholds.

For individuals, the NIIT applies to the lesser of two amounts: your net investment income, or the amount by which your modified adjusted gross income, or MAGI, exceeds the threshold for your filing status.

For example, if you’re single with MAGI of $230,000, including $50,000 of net investment income, your MAGI exceeds the $200,000 threshold by $30,000. The NIIT applies to the lesser of $30,000 or $50,000, which is $30,000, resulting in a tax of $1,140.

Income thresholds

According to the IRS, the NIIT thresholds based on modified adjusted gross income are $200,000 for single and head of household filers, $250,000 for married couples filing jointly and qualifying surviving spouses, and $125,000 for married filing separately.

Importantly, these amounts are not adjusted for inflation. As incomes rise over time, more people may become subject to the NIIT.

Estates and trusts have their own, much lower threshold, which is tied to the income level at which the highest trust income tax bracket begins.

What counts as net investment income

Net investment income generally includes interest, such as interest from bonds, savings accounts and CDs, but not tax-exempt interest from municipal bonds. It includes dividends, both qualified and ordinary. It includes capital gains from selling stocks, bonds, mutual funds, investment real estate and other investment property. It includes rental and royalty income, unless the rental activity is part of a trade or business in which you materially participate or other exceptions apply. And it includes passive business income from businesses in which you don’t materially participate.

Net investment income is reduced by certain deductions properly allocable to that income, such as investment interest expense and certain state and local taxes.

What generally doesn’t count

Several types of income generally aren’t net investment income. These include wages and self-employment income, which may be subject to the separate additional Medicare tax instead, Social Security benefits, distributions from qualified retirement plans, such as 401(k)s, 403(b)s and IRAs, including Roth IRAs, tax-exempt interest from municipal bonds, income from businesses in which you materially participate, and gain on the sale of your main home that’s excluded from income under the home sale exclusion.

Although retirement plan distributions aren’t net investment income themselves, they increase your MAGI, which could push you over the threshold and cause other investment income to become subject to the NIIT.

Ways to manage the net investment income tax

Hold investments in tax-advantaged accounts. Investment income earned within 401(k)s, IRAs and other qualified retirement accounts isn’t subject to the NIIT. Maximizing contributions to these accounts can also reduce your MAGI if contributions are pre-tax.

Use tax-loss harvesting to offset gains. Selling investments at a loss to offset capital gains reduces your net investment income.

Consider municipal bonds. Interest from tax-exempt municipal bonds isn’t counted as net investment income and doesn’t increase your MAGI for NIIT purposes, though it may affect other calculations.

Time large gains carefully. If you’re planning to sell a business, investment property or a large investment position, consider timing the sale for a year when your other income is lower, or spreading gains across multiple years through installment sales, where appropriate.

Give appreciated assets to charity. Donating appreciated stock or other assets directly to charity, rather than selling them and donating cash, avoids recognizing the capital gain, which reduces net investment income. Charitable remainder trusts can also help spread out gains.

Consider your level of participation in businesses. Income from businesses in which you materially participate isn’t subject to the NIIT, though it may be subject to self-employment tax.

Manage the timing of Roth conversions and retirement distributions. Since these increase MAGI, timing them in lower-income years can help keep other investment income below the threshold.

Consider tax-efficient investments. Index funds and ETFs that distribute fewer capital gains can reduce taxable investment income in taxable accounts.

Reporting the NIIT

The NIIT is calculated on IRS Form 8960 and reported on your federal income tax return. It may also affect your estimated tax payments, so taxpayers expecting to owe the NIIT may need to account for it when making quarterly payments.

Get advice

The NIIT rules can be complex, especially for people with rental properties, business interests or trusts. A tax professional can help you estimate your exposure and develop strategies to plan around the NIIT as part of your overall tax planning.