The goal of planning net investment income tax (NIIT) is to manage the adjusted gross income and net investment in order to reduce the total amount subject to federal tax. The net investment income tax is calculated using the lesser of the net investment income or the adjusted gross income over the tax threshold amount for the year.
How Is The Net Investment Income Tax Calculated?
The net investment income tax is a surtax at a 3.8% tax rate of a base income. The base income is the lesser of:
- Net investment income
- Modified AGI above the threshold
Filing Status of Taxpayer Modified AGI
Single and Head of Household $200,000
Married Filing Jointly, Qualified Widower or Widow $250,000
Married Filing Separately $125,000
If you are trying to reduce your net investment income tax, you could reduce the net investment income, AGI or both. If your adjusted gross income is lowered below the threshold, the net investment income wouldn’t apply to you because it created a negative amount that becomes zero. Also, if the adjusted gross income is above the threshold, reducing the net investment income and/or AGI lowers the amount of your income that is subject to net investment income tax.
If you reduce your capital gains amount earned during the year, your income will be reduced and your AGI will be reduced. It is important to remember that the adjusted gross income is your total income less all the first page deductions on the first page of the IRS form 1040. All itemized deductions don’t reduce your adjusted gross income.
Two Basic Net Investment Income Tax Planning Strategies
- Reduce AGI below the threshold
- Reduce your net investment income
- Life Insurance. Growth in a life insurance policy is sheltered from current income taxes. Additionally, the death benefit is also tax-free. Placing assets directly into life insurance removes that investment income from net investment income and AGI.
- Roth 401(k) or Roth IRA plans. Qualified distributions from a Roth retirement plan are not included as income.
- Deferred Annuities. Consider using deferred annuities after all 401(k) and contributions to retirement plans have been maxed out. Annuities will shelter your earnings from immediately being taxed. They will help you smooth out your income and help keep your AGI under the NIIT threshold.
- Possibly convert Pretax Retirement Plans into a Roth plan. Taxpayers need to determine if this will make sense for them. The amount that is converted into a Roth plan increases adjusted gross income and income which could potentially cause income tax liability and net investment income tax liability. However, future income distributions from the Roth IRA will be exempt from tax.
Passive Income Strategies
Consider investments where your investment can be depreciated. For example, rental real estate can be depreciated. Depreciation reduces the total rental income that is taxable. Another option is gas and oil investments. These offer a large deduction for depletion that can be taken upfront and a deduction for most of the intangible drilling costs. These deductions give gas and oil investments more tax advantages than many other investments. Both of these strategies help reduce the total investment income that is taxable.
Many taxpayers own real estate and rent their building to directly to their own business (self rentals). These may be subject to a 3.8% net investment income tax.
When taxpayers own multiple passive businesses or rental properties, they should consider how these activities are grouped to calculate passive activity loss limitations. The IRS provides taxpayers an opportunity to regroup these activities which can be a better way to handle passive losses. It can reduce the amount of income that is subject to federal tax.
Strategies for Capital Gains
Installment Sales. Taxpayers that are selling major capital assets or real estate should think about using installment sales. The seller directly finances the purchase using a loan. Taxpayers will then have the choice of whether they want to spread the capital gains over a loan’s life or not. This will help smooth income for the number of years of the loan.
Charitable Remainder Trusts. Property can be placed in a charitable remainder trust and the taxpayer can draw distributions over the rest of the taxpayer’s life. The remainder will go to charity. The distributions are subject to the net investment income tax but it can be done over many years. Taxpayers, for example, can sell appreciated assets from inside of the charitable remainder trust and income can be distributed over many years.
Charitable Lead Trusts. Taxpayers get an upfront charitable deduction and they are able to keep the gains off of their tax returns. This is a good option for extremely generous taxpayers.