Net Investment Income Tax: Impact on High-Net-Worth Portfolios | Financial Advisors


Advisor’s Corner

If you’re a high earner with investment income, you may be in for a not-so-pleasant surprise when tax time arrives.

The intention of the net investment income tax (NIIT) is to raise funds for the Affordable Care Act. However, unlike other U.S. tax code provisions that adjust higher to keep pace with inflation, this tax has remained unchanged for a decade.

According to a June 2023 report by the Congressional Research Service, because NIIT income thresholds are not indexed for inflation, “more taxpayers become subject to the tax over time regardless of whether their real, inflation-adjusted income has increased, or increased significantly.”

The report noted that indexing the income thresholds for inflation would address this issue.

“Other components of the tax code, such as the ordinary income tax brackets and the standard deduction, are indexed for inflation,” the Congressional Research Service said.

Here’s what you should know about the net investment income tax:

“High-net-worth investors often have substantial investment income,” says Mark Friedlich, vice president of government affairs at Wolters Kluwer Tax and Accounting in New York, via email.

“NIIT can significantly increase tax liabilities for these individuals,” he adds. “Common sources like dividends, capital gains and passive income are subject to the additional 3.8% tax.”

“Individuals with modified adjusted gross income over $200,000, or $250,000 for married couples filing jointly, may be subject to NIIT,” Friedlich says.

This tax applies to either the lesser of net investment income or the amount by which modified adjusted gross income, or MAGI, exceeds the threshold, Friedlich adds.

You’ll face the net investment income tax if you have both investment income and modified adjusted gross income, or MAGI, above the threshold. So, first confirm that your MAGI rises to that level, says Matt Foster, senior wealth advisor at The Colony Group in New York. He points out that unless you have foreign income, your MAGI is likely the same as your adjusted gross income, or AGI.

“Then, think about whether you own investments where you are a passive participant. The most common examples are brokerage accounts that hold publicly traded securities,” Foster says.

Each time you sell a stock, exchange-traded fund or mutual fund at a gain, you’ll face the NIIT’s additional 3.8% charge.

“So, if you pay a 20% capital gains rate, because of the NIIT, your federal long-term capital gains tax rate is in fact 23.8%,” Foster says.

The NIIT typically does not apply to investments where the asset holder is an active participant.

“For example, when our business owner clients decide it’s time to sell their business, any gain on the sale is not passive and therefore NIIT is not due,” Foster says.

“The net investment income tax is a surtax on investment income,” says Sean Mullaney, a financial planner at Mullaney Financial & Tax in Woodland Hills, California.

The NIIT first affected taxpayers in 2013, and until recently, was applied in an environment of fairly low yields, Mullaney says.

That means that for many high-net-worth taxpayers, NIIT didn’t have much of an impact. But, he adds, “the net investment income tax becomes more impactful as yields – particularly bond yields – and interest rates rise.”

To minimize the tax’s effect, high-net-worth investors should think strategically. There are several steps investors can take.

“To reduce the impact of net investment income tax, you can try to reduce your MAGI below the income thresholds where NII kicks in,” says Dave Zaegel, president and co-founder of the financial planning firm CWOs For Hire in St. Louis.

For example, Zaegel says, a high-net-worth investor might consider contributing as much as possible to a 401(k) plan to reduce overall taxable income.

“If reducing ordinary income is not an option, then you can harvest investment losses, meaning that you can look to sell investments that have lost value since you purchased them,” Zaegel says.

That would reduce the total investment gains that would be subject to the 3.8% net investment income tax.

Other strategies include increasing tax deductions or salary deferrals. “Examples include maximizing contributions to retirement plans with pretax dollars,” Foster says.

Charitable contributions may also reduce MAGI, he adds.

The NIIT also applies to estates and certain types of trusts, but the AGI threshold at which the NIIT begins to apply for trusts is much lower than for individuals, Foster says.

“Trustees of trusts where the NIIT applies can reduce or avoid paying the NIIT tax by distributing income to beneficiaries, so long as doing so is in accordance with the trust’s terms,” Foster says.

However, when income is distributed from a trust, the beneficiary becomes responsible for the taxes due.

“Distributing income may result in an overall tax savings if the beneficiary’s MAGI is lower than the NIIT thresholds,” Foster says.

U.S. News makes no representations or warranties in connection with the information provided herein, nor to the accuracy or applicability thereof. U.S. News does not give, offer, or render tax, credit, or legal advice. Before making financial or investment decisions, U.S. News recommends that you contact an investment advisor, or tax or legal professional.

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