Navigating the tax landscape can be challenging, especially when dealing with specific taxes like the net investment income tax (NIIT). Both high-income individual investors and estate or trust managers need to understand this tax and its potential impact on finances.
What Is Net Investment Income Tax?
The net investment income tax (NIIT), a tax that affects individuals, estates, and trusts with incomes that surpass specific thresholds. This taxes 3.8% of your net investment income. The net investment income tax rate was introduced under the Affordable Care Act in 2013. It’s specifically designed to target individuals with higher income from investments.
For individuals, it applies to the lesser of your net investment income or your excess modified adjusted gross income (MAGI) that goes beyond these thresholds:
- Single filer/Head of household: $200,000
- Jointly filing married couples/Qualified widow(er) with a dependent: $250,000
- Separately filing married couples: $125,000
For estates and trusts, net investment income tax applies to the lesser of either:
- The undistributed net investment income
- The amount by which adjusted gross income exceeds the threshold for the highest tax bracket
What is Subject to Net Investment Income Tax?
Net income investment tax doesn't apply to all income sources, so what income is subject to net investment income tax?
Taxable income can include interest earned, dividends received, and any capital gains realized. Also, rental and royalty income can contribute to your overall net investment income. Non-qualified annuities play a part as well.
It's worth mentioning that income derived from businesses engaged in trading financial instruments or commodities falls under this category, too. Lastly, suppose you have any passive activities related to your business. In that case, that income should also be considered part of your net investment income calculation.
There are a few exceptions to remember regarding taxable net investment income, like income from a business you actively participate in. Another exception applies to qualified retirement plan distributions from a 401k or a traditional IRA. These retirement plans have specific provisions allowing for tax advantages.
How to Avoid Net Investment Income Tax
Suppose you're looking to reduce your tax burden. In that case, there are effective strategies you can employ to lower or avoid your net investment income or modified adjusted gross income (MAGI) below the threshold for this tax.
1. Consider Tax Exempt Options
You can reduce your net investment income by considering tax-exempt or municipal bonds. These types of investments often exclude the interest earned from being included in the net investment income tax.
2. Be Strategic with Your Capital Gains
Take control of your capital gains by strategically timing when you realize them. This can have a significant impact on your net investment income. To maximize your financial benefits, consider offsetting gains with losses or deferring payments to a year when you anticipate falling below the net investment income tax threshold.
3. Get Qualified Retirement Plans
Investing in qualified options such as 401(k)s, or traditional IRAs can secure your future and potentially lower your Modified Adjusted Gross Income (MAGI). This is because contributions to these accounts are typically deductible, giving you more control over your tax liabilities.
4. Gift Investments
Consider gifting income-producing investments to family members in lower tax brackets. This strategy not only helps you reduce your own net investment income but also provides your loved ones with a valuable asset that can generate additional income for them. It's a win-win situation that can have long-term benefits for everyone involved.
5. Make Charitable Donations
By donating appreciated securities to charitable organizations, you can enjoy the benefits of reducing your net investment income and your modified adjusted gross income (MAGI). This allows you to support causes close to your heart and provides potential tax advantages.
6. Consider Investing in Growth Stocks
To effectively lower your net investment income, allocate a portion of your investment portfolio towards growth stocks. By opting for stocks that do not pay dividends, you can optimize the potential for growth and increase the value of your investments over time. With this strategy, you can delay paying taxes until you decide to sell the shares and make a profit. This is an intelligent way to manage your tax responsibilities while still taking advantage of possible increases in stock prices.
Work with Financial Experts
Understanding and navigating tax laws, particularly regarding strategies related to net investment income tax, can be quite challenging due to their intricate nature.
Working with Asset Preservation Wealth and Tax can remove some hurdles that stop you from reducing your tax liability. Our tax services and financial planners will cover your unique circumstances. You can get a personalized strategy that reduces this tax and aligns with your long-term financial objectives.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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