How to Avoid the 3.8% Tax on Investment Income

The NIIT is the least-known of the Stealth Taxes and the one most likely to surprise retirees.The net investment income tax (NIIT) was created in the Affordable Care Act. It was labeled a Medicare surtax, but the proceeds go into general revenues not the Medicare trust fund.

The NIIT is a 3.8% tax on the excess unearned, or investment, income. It is imposed on single tax-payers with modified adjusted gross income (MAGI) exceeding $200,000 and married couples filing jointly with MAGIs above $250,000.

The income thresholds aren’t indexed for inflation, so more people will owe them over the years. MAGI for this tax is your regular adjusted gross income (AGI), plus any foreign earned income that qualified for the exclusion from gross income.

Unearned income includes interest, dividends, capital gains, annuity distributions (taxable distributions only, when not from a qualified retirement plan), royalties, and passive real estate rental income. Income from a trade or business is included if it is a passive activity for you.

The tax doesn’t apply to tax-exempt interest, Veterans Administration benefits or gains from the sale of a principal residence that’s excluded from gross income.

Distribution from IRAs, 401(k)s and other qualified retirement plans also don’t count as investment income. After computing investment income, net investment income is determined by subtracting any in-vestment-related expenses.

The NIIT is imposed on the lesser of net investment income and the amount of MAGI above the threshold. Suppose Max and Rosie Profits have net investment income of $30,000 and MAGI of $270,000. The excess of MAGI over the threshold is $20,000.

That’s lower than their net investment income of $30,000, so they pay the tax based on $20,000. Multiplying $20,000 by 3.8% results in an NIIT of $760. Suppose that instead the Profits’ MAGI is $290,000.

In that case, the NIIT is lower than the difference between MAGI and the threshold, so the tax would be computed on the net investment income. That tax would be 3.8% of $30,000, or $1,140.

Capital gains and qualified dividends are included in net investment income, so the NIIT effectively increases the maximum tax rate on those sources of income.One trick to this tax is that all sources of income increase your MAGI and potentially trigger the tax, but only the “unearned” income is subject to the tax.

For example, you might take an additional IRA distribution to pay medical expenses. IRA distributions aren’t subject to the surtax. But the distribution will increase your MAGI and could push you from an income level that is exempt from the surtax into one that pays the surtax on all your unearned income.Here are strategies to consider, to avoid paying the Medicare surtax on investment income.

Consider NIIT before taking significant capital gains.

The gains could push you into the income range that’s subject to the NIIT. Plus, the gains themselves will be subject to the NIIT. In that case, you’ll pay a higher tax on the gains. You might want to spread the gains over several years or search your portfolio for losses to offset some of the gains.Business owners need to realize the surtax will apply to the sale of a business. That’s an extra 3.8% tax in addition to the other taxes and the costs of selling.

Tax-exempt bonds.

When your income is high enough to trigger the surtax regularly, shifting some income investments to tax-exempt bonds instead of some other types could both lower your MAGI and avoid or reduce the surtax.

Convert traditional IRAs to Roth IRAs.

Distributions from traditional IRAs and pensions are exempt from the surtax, but they increase your MAGI and can trigger the surtax on your investment income. When retirement plan distributions, combined with your other income, is likely to trigger the surtax, you’ll reduce taxes in the long term by converting traditional IRAs to Roth IRAs. Roth IRA distributions are not included in MAGI.

It is a factor that could tip the balance in favor of converting IRAs if the benefits of a conversion were on the borderline.Keep in mind, however, that in the year of conversion, the amount converted will be included in your MAGI and could trigger the surtax on other investment income.

Review deferred compensation strategies.

A classic tax strategy is to defer income and taxes, especially on compensation.

You might want to reconsider such strategies. The deferred compensation will be included in MAGI and could trigger MAGI in later years.

Reduce AGI.

Almost everything that decreases your AGI also decreases MAGI and helps avoid or reduce the NIIT. Strategies for reducing AGI are discussed in our July 2018 and March 2017 issues.

NIIT is computed and reported separately on Form 8960, which should be included with your Form 1040.