The Net Investment Income Tax

The 3.8% surtax for higher-income individuals began with the 2013 tax year

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The net investment income tax might take a bite out of your finances even if you manage to dodge the bullet on paying significant income taxes through the use of deductions, credits and other tax perks. The tax hits high earners with significant investment income. 

The Basics 

The net investment income tax is a 3.8 percent surtax on the portion of your modified adjusted gross income over certain thresholds: $200,000 if you're single, $250,000 if you're married filing jointly or $125,000 if you're married filing separately.

These amounts aren't indexed for inflation, which means they won't increase unless Congress specifically changes them through new legislation.

But there's a catch, and it can work in your favor. If your net investment income is less than the portion of your MAGI over these amounts, you would pay 3.8 percent of this instead. 

And yes, a "surtax" mean it's extra, over and above your income tax obligation. It's also over and above what you paid into Medicare through withholding from your earned income or estimated tax payments. But you're only subject to it if you have both net investment income and your MAGI exceeds these thresholds. 

Historical Background

The net investment income tax was legislated as part of the Health Care and Education Reconciliation Act of 2010, which, along with the Affordable Care Act, reformed the health care market by requiring individuals to obtain health insurance or pay a tax penalty.

This tax was included as a revenue raiser in that legislation. The Joint Committee on Taxation estimated that together with the Additional Medicare Tax, the net investment income tax would generate an additional $20.5 billion in tax revenue in the year 2013, the first year the surtax would be in effect.

The Joint Committee on Tax estimates this surtax will generate an additional $210.2 billion in tax revenues over the 10-year period from 2019 through 2019.  

Calculating the Net Investment Income Tax for Individuals 

Here's how to figure out how much you'll owe, if anything. First, calculate your MAGI. Start with your adjusted gross income, which appears on line 37 of your Form 1040. Now add back some of the deductions you took to arrive at this number, including:

  • Student loan interest, qualified tuition expenses, and the tuition and fees deduction
  • The deduction for half your self-employment taxes
  • IRA contributions
  • Taxable Social Security payments
  • Rental losses
  • Passive loss or passive income 
  • Adoption expenses exclusion 
  • U.S. savings bond income exclusion 
  • Losses from a publicly traded partnership 

This is your modified adjusted gross income. Now compare it to your net investment income for the year. This includes what you earned from investments such as stocks, bonds, mutual funds, annuities, royalties, rental income, and interest on loans you might have extended to others. It also includes income derived from a trade or business that is passive income, income from a business trading financial instruments or commodities, and net capital gains except gains on property held in a trade or business.

 You can subtract your expenses from the total – costs you incurred to maintain these investments, such as brokerage fees and tax preparation fees. Other deductions that can reduce net investment income include: 

  • Deductions related to producing rental and royalty income
  • Deductions related to producing business income
  • Penalty on early withdrawal of savings
  • Investment interest expenses
  • Miscellaneous investment expenses
  • The portion of state income tax that relates to net investment income
  • Casualty and theft losses related to property that was sold or disposed.

Some of these deductions are already included in the investment income figures. Rental income, royalty income, business income and net capital gains will already be a net amount of income after deductions or losses have been taken into account.

Other deductions, however, are not included in these net figures, so they must be deducted against investment income to arrive at net investment income. These separate deductions include the penalty on early withdrawal of savings, investment interest, investment expenses, state income tax allocated to investment income, and casualty and theft losses related to investment property.

Taxpayers who invest in controlled foreign corporations and passive foreign investment companies may need to make further modifications to their adjusted gross incomes. If you derive any income from these sources and your MAGI exceeds the threshold for your filing status, you might want to consult with a tax professional to make sure you get your calculations right. 

The net investment income tax is due on the lesser of your net investment income or the portion of your MAGI that exceeds the thresholds: $200,000, $250,000 or $125,000. Multiply that number by 3.8 percent. 

Who is Subject to the Net Investment Income Tax?

The net investment income tax is imposed on estates and trusts as well as individuals. For individuals, it applies to U.S. citizens and resident aliens. It does not apply to non-resident aliens unless the individual elects to be treated as a resident of the U.S. for tax purposes.

The net investment income tax applies to estates and trusts when the estate's or trust's adjusted gross income for the year exceeds the dollar amount at which the highest tax bracket begins. 

Where Does the Tax Revenue Go?

The official name of the net investment income tax is the "Unearned Income Medicare Contribution Tax." This suggests that the tax revenue is used to fund Medicare, but the revenue raised by this tax actually goes into the nation's General Fund. In their summary of the new Medicare surtax, the Joint Committee on Taxation points out that "no provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund." 

In its preamble to the regulations, the IRS stated, "Amounts collected under section 1411 are not designated for the Medicare Trust Fund." 

The net investment income tax, which is the phrase used by the IRS on tax form 8960, is a better name for this tax.