The net investment income tax is an onerous tax on the middle class that fellow optimizers should work to avoid.  The net investment income tax is a surtax on unearned income. It’s computed at 3.8% of the lesser of 2 amounts:
1) Net investment income for the taxable year, or
2) The excess of modified adjusted gross income (MAGI) for the taxable year over a threshold amount

A taxpayer that has neither net investment income nor MAGI in excess of the threshold, or only has one is not subject to the tax.

The threshold amounts are:

  • $250,000 for taxpayers filing a joint return or a surviving spouse
  • $125,000 for a married taxpayer filing separately
  • $200,000 in ALL other cases

NII thresholds

Therefore, an individual that earns net investment income of $10,000 and has an income (as single filer) of $100,000 has no requirement to pay the 3.8% surcharge. This hypothetical person’s income is too low for the tax. Individuals need to make $200,000 to hit the threshold

 Net investment income is the sum of all the following:
  • Income from interest, dividends, annuities, royalties, and rents unless derived in the ordinary course of business
  • The net gain included in taxable income from the disposition of property (unless the property was held in a business that’s not a passive activity)
  • Gross income from a business that is a passive activity

MAGI is Adjusted Gross Income (AGI) plus:

  • Any deductions or exclusions disallowed related to foreign earned income
  • tax-exempt interest income
  • student loan deductions and some higher ed costs
  • IRA-contribution deductions
Form 8960 is required to be filled out if you owe the net investment income tax and the instructions that go along with the form are pretty clear cut for people who file their own taxes.

Example #1

Let’s say an individual earned $30,000 from dividends and interest and their MAGI is $250,00 (single filer). The IRS states that this person is subject to the 3.8% net investment tax on the lesser of the net investment income or the difference between MAGI and the $200,000 threshold for individuals. This person is subject to the surcharge of 3.8% on $30,000 or $1,140 in tax. This is on top of all the other taxes that this person pays, which is quite a bit at their income level.

This person would be paying approximately $60,000 in federal taxes at an income level of $250,000 income level. Add in state taxes and payroll taxes and this person is paying around $85,000 in some sort income tax.

Example #2

In example #2, let’s say a family earns $100,000 from dividends and interest and their MAGI is $500,000. This family is subject to the surcharge of 3.8% on $100,000, or $3,800 in tax.  This is the lesser of their investment income and the difference between the $500,000 MAGI – $250,000 threshold.

Therefore, this family owes $3,800 in additional tax on their investment income, which is already being taxed at 20% because they are in the top tax bracket. In total this family earns $100,000 in income and pays $20,000 in regular tax plus $3,800 in net investment income tax for a total tax rate of 23.8% on their dividends and interest.

Lowering Your Taxes

It’s really important to put long-term tax planning strategies to work in a high-tax environment. There are many different ways to lower your tax bill but we’ll just touch on a couple here. To get out of paying the net investment income tax, you’ll need to either lower your MAGI or lower your dividend and interest income. Either option doesn’t sound great but here are some more palatable options.

1) Invest in zero-coupon municipal bonds that don’t pay interest. If you’re invested in bonds (Corp or Fed) that currently pay semi-annual interest, you could benefit by transferring those investments to zero-coupon muni bonds. These are bonds that are discounted at face value and then you get face value when they mature. They pay no interest. For example, you buy 5-year bond $1,000 face value bond at $750. In five years, you get $1,000 back, or $250 above your initial investment.

Regular zero-coupon corporate bonds won’t cut it because you still have to pay tax on the phantom income, that is income that is implied but not paid out to the investor. For example, if you buy a 2-year corporate bond at $900 with a face value of $1,000, you’d have to pay tax on $50 of phantom income ($1,000 – $900 / 2 years). Even though you didn’t receive the cash, there is still a tax obligation.

You do need to include muni bond income when calculating your MAGI even though you don’t pay taxes on muni bond income. Therefore, it makes sense to invest in zero-coupon municipal bonds to lower your federal taxes and the phantom income that is provided to you is not reported.

This may seem a bit complicated and it’s important to talk to your tax advisor prior to buying a zero-coupon muni bond to make sure that you won’t be blindsided with anything. But the tax law is pretty cut and dry: no tax due on phantom muni bond income.

2) Focus on increasing passive income instead of continuously increasing your earned income. You’re taxed less if you make $20,000 in dividend income versus $20,000 in earned W2 income. You may be able to work out stock options  or some other type of deferred compensation with your employer if you have leverage. At some point it just doesn’t make sense to make more in earned income because you’ll end up paying more than 50% in taxes. What’s the point of that? Here’s the difference in tax due on dividend income versus earned income (both employee and self-employed):

Dividend Income:

$20,000 taxed at 0% if you’re in the 10 or 15% tax brackets = $0 tax due

$20,000 taxed at 15% if you’re in the 25 – 39.6% tax brackets = $3,000 tax due

$20,000 taxed at 20% if you exceed the 39.6% tax bracket = $4,000 tax due

Earned income (employee):

$20,000 taxed at 6.2% for SS, 1.45% for Medicare, 28% Federal tax bracket, and 8% state tax bracket = $8,730 tax due

Earned Income (self-employed):

$20,000 taxed at 12.4% for SS, 2.9% for Medicare, 28% Federal tax bracket and 8% state tax bracket = $10,260 tax due

It’s not that easy to avoid paying the net investment income tax. You have to make big changes to either your earned income or your passive income. No one is going to tell their employer to pay them less because of tax, but there may be ways to defer compensation into the future. You could also adjust your investments to throw off fewer dividends and interest. We discussed the muni bond shelter and you could also invest in companies that don’t pay a dividend like Berkshire Hathaway. Have you found another way to beat the tax man? Please let me know!