ARE YOUR PASSIVE INVESTMENTS COSTING YOU MORE IN TAX?

By Erik Casarrubias | Senior - Tax

In the realm of taxation, the Net Investment Income Tax (NIIT) stands as a critical component of the Affordable Care Act (ACA), commonly referred to as Obamacare. Designed to aid in funding the Affordable Care Act (ACA), the Net Investment Income Tax (NIIT) was created to add additional tax on investment income earned by individuals, estates, and trusts. Since 2013, typically, NIIT applies to high earners with significant investment income. As a result, taxpayers who surpass the income threshold must carefully evaluate their tax planning strategies and consider the implications of the additional 3.8% tax on investment income. In this article, we dive into the potential impact of passive investments on your overall tax liabilities, providing insights and guidance for individuals, estates, and trusts with significant amounts of investment income.

The net investment income tax applies a rate of 3.8% to certain taxpayers with passive sources of investment income, typically high-net-worth individuals with sizable amounts of assets. NIIT is defined as income earned from investments such as interest, dividends, and capital gains. In addition, rental, and royalty income as well as some types of annuity payments may be subject to this tax. Lastly, income from businesses involved in trading financial instruments or commodities may fall under this tax situation.

Types of income sources that are not subject to the NIIT are income from wages, unemployment compensation, social security, alimony, self-employment income, and distributions from qualified accounts.

Taxpayers may be subject to net investment income tax if their passive investment income and modified adjusted gross income (MAGI) is above a certain threshold. The threshold amount is based on the taxpayer’s filing status and applies to the amount of net investment income that exceeds that threshold.

For example, a couple’s filing status is married filing jointly with a $300,000 modified adjusted gross income and their NIIT threshold is $250,000 per the above grid. $300,000 less $250,000 equals a $50,000 excess. The couple’s total passive investment income for the tax year is $75,000. The taxpayer would then be paying 3.8% on the lesser of either the excess amount or their total passive investment income. Thus, the couple will be paying an additional $1,900 in taxes ($50,000 x 0.038).

Net Investment income tax could also be a concern for those who are in retirement and rely on living off their passive investment income. Although social security, pensions, IRAs, and tax-deferred retirement account distributions are not subject to NIIT, those income sources may increase your MAGI which in return may make you subject to NIIT. Therefore, it is important for retirees to be aware of the potential impact NIIT may have before making any considerable investment sales or conversion.

Taxpayers who think they may be subject to net investment income tax should seek various strategies to avoid or mitigate this tax. The most notable way to avoid this tax would be through keeping income below the threshold. As mentioned previously, NIIT only applies when the taxpayer’s modified adjusted gross income is above a certain threshold, therefore, by keeping income below these thresholds, one may be able to avoid NIIT entirely. Taxpayers may also consider reducing their NIIT through tax-loss harvesting.

As an example, through this strategy, taxpayers should sell poorly performing investments that have decreased in value which can offset gains from other investments. Doing so will help reduce overall investment income and potentially keep the taxpayer below the threshold. Due to the complexity of NIIT and the tax code, there is no blanket strategy, and it is important to consult with our tax professional or CPA before making any investment or tax-related decisions.

Contact Erik at erik.casarrubias@krostcpas.com to schedule a meeting to review your investments and learn more about how you can save more in taxes.  https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax https://www.youtube.com/watch?v=q9WpkT2Sjws https://www.forbes.com/advisor/investing/net-investment-income-tax https://asenaadvisors.com/blog/how-to-avoid-the-net-investment-income-tax