📊 NIIT: The 3.8% Surprise You Didn't Ask For

☕ Good morning!

Ever feel like tax rules keep popping up out of nowhere? 

Many felt the same when the Net Investment Income Tax (NIIT) came out in 2013. 

The NIIT adds an extra 3.8% tax on certain investment income for high earners with significant modified adjusted gross incomes (MAGIs).

This week, we’re going over NIIT basics, how it could affect your tax bill, and, importantly, what you can do today to keep more of what you earn. 

The NIIT threshold is a Modified Gross Income (MAGI) of $200,000 for single filers or $250,000 for married couples filing jointly. 

Income that counts and doesn’t count for NIIT

💰 Interest Income: This is what you earn from savings accounts, CDs, and bonds.

 📈 Dividends: Money from stocks, including both qualified and non-qualified dividends.

🏦 Capital Gains: Profits from selling stocks, bonds, and real estate that isn’t your main home.

 🏠 Rental and Royalty Income: Earnings from rental properties and royalties from things like intellectual property.

💸 Non-Qualified Annuities Distributions from annuities that don't qualify for tax deferral.

The NIIT doesn’t touch your wages, benefits, or retirement plan distributions. Phew! 😅

It also excludes:

💼 Wages: Your regular paycheck.

👨‍💻 Self-Employment income: Earnings from your own business.

🏦 Tax-exempt interest: Interest from municipal bonds.

And in your later years: 

🏝️Retirement Plan Distributions: Withdrawals from 401(k)s, IRAs, etc.

🧓 Social Security Benefits: Payments from Social Security.

So, while the NIIT does scoop up a lot of investment income, at least it leaves your everyday earnings and retirement funds alone. ✨

Still, you’re only affected if your MAGI (Modified Adjusted Gross Income) exceeds the below thresholds AND you have net investment income.

• $200,000 for single filers

• $250,000 for married couples filing jointly

• $125,000 for married couples filing separately

📝 MAGI 101: It's basically your total income (wages, investment income, and other sources) with certain deductions added back in. It’s used to determine eligibility for various tax benefits and credits.

🧮 How to calculate MAGI:

1. Start with your AGI (Adjusted Gross Income).

2. Add back certain items like tax-exempt interest (from municipal bonds), IRA contributions, and passive income or losses.

For the nitty-gritty details, check out the IRS instructions for Form 8960.

It’s important to note that this tax is triggered explicitly by having MAGI over the threshold AND net investment income. 

If, in theory, your MAGI is much higher than the thresholds, but you don’t have investment income, you’re not affected by the NIIT. 

📊 How NIIT is Calculated 

The NIIT is 3.8% of the lesser of:

• Your net investment income, or

• The amount of your MAGI exceeds the threshold.

Example Time:

1. Sarah, Single Filer:

   • MAGI: $250,000

   • Net Investment Income: $60,000

   • MAGI Excess Over Threshold: $50,000 ($250,000 - $200,000)

Since her MAGI is less than her net investment income, it’ll be used to calculate her NIIT.

NIIT Calculation: 3.8% of $50,000 = $1,900

If Sarah’s investment income were lower than her MAGI, we’d use her investment income:

• MAGI: $250,000

• Net Investment Income: $30,000

NIIT Calculation: 3.8% of $30,000 = $1,140

 🧮 How to Calculate Your NIIT

Your tax planning software or your financial planner usually does this for you, but here’s how it gets done:  

1. Determine your MAGI, which requires adding back certain deductions to your AGI.

2. Sum up all your investment income and subtract related expenses (like investment interest expenses and advisory fees) to identify your net investment income.

3. Apply the 3.8% NIIT to the lesser amount.

For example:

1. MAGI: $250,000

2. Net Investment Income: $70,000

3. Excess Over Threshold: $50,000 ($250,000 - $200,000)

4. NIIT: 3.8% of $50,000 = $1,900

🛡️ Shielding yourself from the NIIT often involves doing financially beneficial things, anyway

There are a handful of strategies aimed directly at reducing your MAGI. Remember, the NIIT is only triggered if your MAGI is above the $200,000 threshold for single filers or $250,000 for couples filing jointly. 

For starters, maxing out your tax-advantaged accounts will lower your taxable income, potentially under the MAGI thresholds, which will limit your NIIT liability.

If you contribute the maximum of $23,000 to a traditional 401(k) or $7,000 to a traditional IRA, you can shave that full amount off your MAGI. 

❤️ Health Savings Accounts (HSA) contributions are also tax-deductible, with a contribution maximum of  $4,150 in 2024.

🕊️If you’re feeling philanthropic, contributing to Donor-Advised Funds (DAFs) allows you to claim a charitable deduction.

And best yet, defer income to a future year when your MAGI might be lower if possible.

The other NIIT reduction angle has to do with reducing investment income.

The two most popular means of doing so are through real estate deductions and tax-loss harvesting.

🏠 Rental property deductions like mortgage interest, property taxes, depreciation, and repairs significantly reduce your net investment income. Further, if you’ve sold a property, you can do a 1031 Exchange to defer capital gains taxes on an investment property by reinvesting the proceeds in similar properties.

💸You can also sell underperforming investments to realize losses to offset capital gains, allowing you to reduce your net investment income significantly.

For example, say you’re sitting on a capital gain of $50,000 from selling profitable stocks. If you’re also sitting on about $20,000 of stocks that happen to be down, you can sell them to reduce your capital gain to $30,000. 

This way, you can avoid subjecting that $20,000 to capital gains tax and NIIT, if applicable.

Just keep in mind that if you sell a security at a loss, you can’t repurchase the same or a "substantially identical" security within 30 days before or after the sale; otherwise, the loss is disallowed for tax purposes.

Making Cents of the NIIT 

Wrapping up our strategies above, it’s helpful to remember that NIIT applies to the lesser of either the MAGI amount over the threshold or the amount of investment income. 

NIIT only becomes a palpable nuisance when you’re well over the MAGI threshold, and that’s where skillful financial planning and taking advantage of an arsenal of tax strategies comes into play. 

 😎 Stay savvy and keep more of what you earn!

1. Instructions and details on calculating the NIIT: IRS Form 8960 - Net Investment Income Tax - Individuals, Estates, and Trusts

2. Detailed explanations of various types of income, including investment income. IRS Publication 525 - Taxable and Nontaxable Income

3. Details on various deductible business expenses can impact your overall taxable income. IRS Publication 535 - Business Expenses

Until next week! 

Dan from Tailored Cents

P.S. Follow me on LinkedIn for more tax gems to save you money.