And then this awkward reality: Inflation will mean many taxpayers ultimately will pay the tax. (If you’re in your 20s, for example, inflation will probably mean you will someday pay net investment income taxes.)
For these reasons, let me briefly describe the tax. And then provide a handful of gambits taxpayers can employ for avoiding the tax
Quick Review of Net Investment Income Tax
To make sure we’re all on the same page, a quick review of the net investment income tax formula makes sense.
The net investment income tax, or NIIT, levies a 3.8% tax on your investment income or a portion of your investment income. This investment income includes interest income, dividend income, capital gains, and then profits from passive investments like rental property or businesses you’re an investor in.
You’re subject to the tax if you’re single and your modified adjusted gross income exceeds $200,000 and if you’re married and your modified adjusted gross income exceeds $250,000.
Note: If you’re married but file using the married filing separately filing status, you’re subject to the tax if your modified adjusted gross income exceeds $125,000.
The 3.8% tax doesn’t apply to all of your investment income, however, if you cross the threshold. The tax applies to the lessor of the following amounts: Your investment income… or the amount by which your modified adjusted gross income crosses the dollar thresholds given earlier.
Note: Your modified adjusted gross income is, in most cases, the same thing as your adjusted gross income.
For example, a single person with $100,000 of investment income and $150,000 of other income pays the 3.8% tax on $50,000 of investment income. The $50,000 value is the lessor of the $100,000 investment income or the $50,000 this single taxpayer’s $250,000 of income exceeds the $200,000 threshold.
And then these two final important points: First, the dollar thresholds are not adjusted for inflation, which means that people are not subject to the tax today will, if they live long enough, become subject to the tax. A household of 20-somethings earning a median income will hit the thresholds at retirement age–even if they always make a median household income.
A second reality to consider, too: Even if you’re not subject to the net investment income tax today based on your regular, continuing income, if you experience an income windfall–which many people do once or twice over their lives–that windfall can rather quickly push you above the thresholds. For example, if your family income equals $55,000 a year (roughly the household average), a $200,000 windfall from the sale of a business or a piece of real estate or even an inherited retirement account will probably subject you to net investment income taxes.
Okay, so that’s how the tax works. And why the tax ultimately will matter to many people. And now we’re ready to talk about how you can either avoid or minimize the tax. Several practical techniques exist.
Avoiding Net Investment Income Tax Tip #1: Use Retirement Accounts
A first, easy tip: Use retirement accounts. Here’s why. Money you draw from a retirement account is not subject to the net investment income tax.
Just so you understand this, assume you’re subject to the net investment income tax and that you have a mutual fund that pays dividends you spend as part of your retirement income. If you hold the mutual fund in a taxable account, you will pay the 3.8% tax. If you hold the mutual fund in a tax-deferred account, you will not pay the 3.8% tax.
Note: I am not a big fan of Roth-style accounts. People often get the income-tax-related math wrong when they consider the tax benefits of a Roth-style account. (See here for more details: Are Roth-style Accounts Really a Good Idea.) But if you’re subject to the 3.8% NIIT, Roth retirement accounts become more attractive.
Avoiding Net Investment Income Tax Tip #2: Substitute Self-employment Taxes
Here’s another tip: You may want to look at making income subject to the 3.8% self-employment tax rather than the 3.8% net investment income tax.
Note that both of these taxes work the same way in a sense. Both use the same 3.8% percentage. Further, the 3.8% Sec. 1401 self-employment tax applies after you cross the same thresholds provided earlier.
But given a choice, you may want to pay the 3.8% self-employment tax rather than the 3.8% net investment income for a couple of reasons. First, 1.45% of the 3.8% tax becomes an income tax deduction. (This is the self-employed taxes deduction.) So that’s a benefit of the 3.8% self-employment tax.
A second thing to keep in mind about self-employment earnings is that they may create an opportunity for you to contribute to pension plans like IRAs, SEPs and 401(k)s.
Note: Typically you would need to be materially participating in an active trade or business organized as a sole proprietorship or partnership to have self-employment earnings.
To give you a quick example of how this works, consider this example. Suppose your other income sources mean you are subject to the net investment income tax and that in addition to that income you have a $100,000 gain from the sale of an investment like a business.
If you need to pay the 3.8% net investment income tax, you pay $3,800.
If you need to pay the 3.8% self-employment tax, you may be able to fund a large $20,000 or even $40,000 pension plan contribution from the $100,000 depending on the character of the gain. Further, you will be able to use 1.45% of the 3.8% self-employment taxes you pay on the net-of-pension-plan-deduction profits as a deduction for income taxes. In the end, then, you might by working the law pay the 3.8% tax on as little as $60,000 of gain.., or just over $2,000.
Avoiding Net Investment Income Tax Tip #3: Qualify as a Real Estate Professional
Another tip—and one that’s too often missed by real estate investors.
If you’re a real estate professional and your activities rise to the level of you operating a trade or business, your real estate profits are not treated as investment income, which means you’re not subject to net investment income taxes on those profit.
A quick example: If you’re subject to the net investment income tax and enjoy a giant $500,000 gain on some real estate deal, you pay $19,000 net investment income tax if you’re not a real estate professional actively engaged in the trade or business of real. You pay zero if you are.
I’ve talked elsewhere in detail about how these rules work, but you want to work the rules to your advantage.
Note: Here’s the link you need: Real Estate Investors and the Net Investment Income Tax
Avoiding Net Investment Income Tax Tip #4: Use the Old S Corporation Gambit
One final note: We talk a lot in this blog’s posts about how small businesses can save lots of payroll tax using an S corporation.
But the same tax accounting that saves an S corporation shareholder-employee payroll taxes also often works to save a taxpayer from paying net investment income tax.
The one thing to keep in mind is that the distributive shares the S corporation allocates to shareholders escape net investment income tax as long as the shareholder materially participates in the business. (A shareholder who doesn’t participate in the business will be subject to the net investment income tax potentially on distributive shares she receives from the S corporation.)
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