Some people don’t know, but there is a net investment income tax of 3.8% that applies to some of your income. Today, I want to discuss what it is, how you can reduce the impact and save money.
Let’s dive in:
Net Investment Income Tax (NIIT)
The net investment income tax is imposed on investment income if the modified adjusted gross income (basically your adjusted gross income for the most part) is more than $200k for single filers or $250k for married filing jointly.
This tax is applied to the lower of:
- Modified adjusted gross income (think of this as your gross income for the most part)
- Net investment income
Example:
Say you have a modified adjusted gross income of $220k. Your net investment income is $40k. You are single. How much tax will you pay?
- $220k – $200k = $20k (above the threshold)
- The amount is the lesser of $20k (above the threshold) or $40k of net investment income
- $20,000 * 0.038 = $760 of tax.
Here are some common examples of investment income:
- Gains from the sale of stocks, bonds, and mutual funds in a brokerage account
- Capital gain distributions from mutual funds
- Gain from the sale of investment real estate (primary residence is excluded, up to $250k/$500k of gain).
- Dividends
- Interest
So, how do we save some money on taxes?
- Interest
Municipal bond (received from city or state) interest is tax-exempt. So, if you have a lot of interest income, consider shifting that to a municipal bond ETF and avoid the NIIT.
However, only make the switch if the muni yield beats what you’d keep after tax from a comparable taxable bond. To check, multiply the taxable yield by (1 – your marginal tax rate), including the 3.8% NIIT, and compare the result to the muni yield.
If the muni yield is higher, the switch pays. If it’s lower, you’d save on taxes but earn less overall, and the goal is the highest after-tax return, not the lowest tax bill.
- Dividends
Dividends count toward the 3.8% NIIT.
As a result, if you want to minimize the impact of NIIT, you can rebalance the portfolio over time to prioritize growth stocks over dividend paying stocks. Personally, my porftolio doesn’t focuses on any high dividend stocks. I obviously get dividends as part of holding broader index funds, but focusing solely on stocks that pay lots of dividends is a tax heavy strategy.
However, make sure that your asset allocation is not impacted as a result of portfolio rebalancing. You don’t want to lose $xx,xxx when the market drops, while trying to save $xxx in taxes.
- Lower your adjusted gross income
If you are below the income threshold, you don’t pay the net investment income tax.
So, make sure to contribute to different accounts that lower your income, like 401(k), 403(b), 457(b), SEP IRA, Traditional IRA (if no 401k plan), and HSA.
- Installment sales
If you can, spread the gains from the sale of investment property over multiple years to reduce the impact on your taxable income.
- 1031 Exchange
If you have an investment property, consider a 1031 like-kind exchange to reduce the impact of the capital gains on the NIIT. This can help you avoid the capital gains that will be subject to the tax.
I hope you enjoyed this one.
See you next Saturday.
Bo, CPA