Look up the word ‘nit’ in the dictionary, and you’ll find a few definitions—none of them particularly positive. So it’s no surprise that the tax commonly known as NIIT can be a bit of an annoyance. NIIT is short for net investment income tax. It originated back in 2013 to help pay for the new healthcare law.
The net investment income tax rate is relatively innocuous at 3.8%, and it’s already been on the books for 10 years, so why talk about it now? It’s worth reviewing because Congress employed a sleight of hand when they created it. As a result, over the years it’s started to creep up on more taxpayers. Specifically, unlike most other taxes, the NIIT isn’t indexed for inflation. When it was created, it applied to taxpayers with adjusted gross incomes over $200,000 (for single filers) or $250,000 (for married couples), but those thresholds haven’t increased since 2013. As a result, as wages have risen, this “little” 3.8% tax has started to apply to more and more people each year. And this trend has accelerated recently because wage growth picked up along with inflation.
What exactly is the NIIT? As its name suggests, it applies only to investment income. For most people, this means dividends, interest and capital gains on investment assets. But if you sell your home for a gain, the NIIT would also apply (above the portion normally excludable). In those cases, this little tax can end up translating into a sizable bill.
Importantly, the NIIT does not apply to employment income or to Social Security. It also doesn’t apply to IRA distributions or to the taxable portion of Roth conversions. And it doesn’t apply to income that isn’t otherwise taxable, such as interest from tax-free municipal bonds. And finally, it doesn’t apply to income generated inside retirement accounts such as IRAs and 401(k)s.
The challenge, though, is that the NIIT doesn’t stand on its own. It’s “stacked” on top of a taxpayer’s other income. As a result, someone might see their NIIT exposure increase even when their investment income did not increase. To understand, let’s look at an example.
Suppose Jane is single and has employment income of $180,000. And suppose she has investment income of $25,000. In this case, her total income would be $205,000, so the NIIT would apply to the $5,000 that exceeded the $200,000 threshold for single filers. The tax would then be $190 (calculated as 3.8% x $5,000).
Now let’s suppose Jane receives a raise the following year, to $200,000, while her investment income stays the same, at $25,000. In this case, since all $25,000 of Jane’s investment income now sits above the $200,000 threshold, the entire amount would be subject to the 3.8% NIIT, for a tax of $950 (3.8% x $25,000). The NIIT, in other words, would rise five-fold just because Jane’s other income rose. That’s a key reason the NIIT is worth paying attention to.
Another reason the NIIT has started to hit more investors’ radar: For most of the past 15 years, interest rates had been extremely low. But with the steep increase in rates over the past year, many investors have seen their investment income rise.
How can you tell if you’ve been impacted by the NIIT? Look for Form 8960 in your tax return. If it’s applicable, you’ll see that form along with the tax calculation.
To some extent, the net investment income tax is a fact of life. And unlike ordinary income taxes, you can’t always reduce your NIIT exposure by increasing your deductions. That’s because the NIIT is based on adjusted gross income (AGI), not on taxable income. Those terms sound similar, but there’s a key distinction: AGI is your income before itemized deductions. So strategies like charitable contributions can’t be used to bring down your NIIT bill. Still, there are other ways to moderate NIIT exposure.
First, consider increasing contributions to your retirement accounts. This is a so-called above-the-line deduction, meaning that it does reduce adjusted gross income and can thus help with NIIT exposure.
On Schedule 1 of your tax return you’ll find a grab bag of additional above-the-line deductions. They are generally less common, but it’s worth reading through the list to see if one might apply.
If you have significant bond holdings in your taxable account, it’s worth considering municipal bonds. In the past, most investors viewed municipals as close cousins of Treasury bonds on the risk spectrum. As we saw in 2020, however, when the pandemic ravaged many municipalities’ finances, municipal bonds definitely do carry more risk than Treasurys. That said, highly-rated munis have a very strong track record. For that reason, you might consider moving a portion of your Treasury holdings over to municipals.
If you hold any actively-managed funds in taxable accounts, they’re worth reviewing. As I described last year, actively-managed funds can generate unexpected and unpleasantly large tax liabilities. That’s because, when a fund’s manager chooses to change up the investments in his or her fund, every investor in the fund shares pro rata in any gains generated by those trades. That’s true even though you have no control over—and worse yet, no visibility into—the timing of those trades. Depending on the funds you hold, it may be worth paying some tax to sell them and swap into broadly-diversified index funds or ETFs, which tend to issue less onerous distributions, if any.
If you have a margin loan, make sure you, or your accountant, has picked up this number. Margin loan interest reduces net investment income dollar for dollar.
And finally, to the extent possible, look for ways to control the timing of your income. For example, if you’re selling a home this year, you might look for ways to delay other income into next year. Or suppose you’re considering a Roth conversion. While this income isn’t itself subject to the NIIT, it does increase overall AGI, and as explained above, that can bump more of your investment income into NIIT territory. That’s a factor worth considering as you decide on both the size and the timing of conversions.