The net investment income tax (NIIT) has been around for more than 10 years, but the number of people subject to it has gradually more than doubled during that time. Why? Because the income thresholds that trigger the tax are not indexed for inflation. As incomes rise with inflation, an increasing number of taxpayers are exposed to the NIIT. Here is how to minimize the threat.

Assessing your risk

The NIIT is an additional 3.8% federal tax on net investment income (NII) from items such as taxable interest, dividends, capital gains, rents, royalties and passive business interests. Certain types of income are exempt, including wages, income from a business you actively manage (except for trading financial instruments or commodities), tax-exempt interest, taxable distributions from IRAs and qualified retirement plans, and Social Security benefits.

It applies to individuals with modified adjusted gross income (MAGI) over $200,000, married couples filing jointly with MAGI over $250,000 and married people filing separately with MAGI over $125,000. These are the same thresholds that applied when the tax was established in 2013. Although NII includes capital gains, the tax does not apply to the tax-exempt portion of your net gain on the sale of a principal residence ($250,000 for single filers, $500,000 for joint filers).

To calculate your exposure, multiply your NII or the excess of your MAGI over the applicable threshold (whichever is less) by 3.8%. For example, if you are a joint filer with $100,000 in NII and MAGI of $300,000, your tax is 3.8% x $50,000, or $1,900.

Strategies for reducing NII and MAGI

In general, you can reduce NIIT by reducing your MAGI or by reducing your NII (which also reduces your MAGI). To reduce your MAGI:

• Increase tax-deductible contributions to traditional IRAs, 401(k) plans and other retirement plan accounts — all of which reduce gross income.
• Make qualified charitable distributions (QCDs) from a traditional IRA. If you are over age 70½, you can donate up to $100,000 per year directly from your IRA to a qualified charity. QCDs apply toward the amount of required minimum distributions you would otherwise have to take, keeping those funds out of your gross income.
• Convert a traditional IRA into a Roth IRA, which can reduce your gross income in future years.

If you want to lower your NII (and also your MAGI):

• “Harvest” capital losses (or sell investments at a loss) to offset capital gains you have realized during the year.
• Reduce taxable interest income by investing in tax-exempt municipal bonds.
• Minimize dividend income by shifting investments into growth stocks that pay low or no dividends.
• Transfer income-producing investments to family members in lower tax brackets (provided the “kiddie tax” does not apply to them).

You may also be able to spread sales of highly appreciated investments over several years to minimize the amount of NII in any single tax year.

Small tax, big bite

A 3.8% tax may seem relatively insignificant, especially compared with federal income tax rates. However, when you compare tax-equivalent returns on various investment alternatives — such as taxable vs. tax-exempt bonds — consider the NIIT. To ensure you are making the most tax-efficient decisions, discuss strategies with your financial advisor.

For more information, contact Eileen Cozzi at 312.670.7444 or [email protected]. Visit ORBA.com to learn more about our Wealth Management Services. Sign up here to receive our blogs, newsletters and Client Alerts.