Many 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 we can reduce its impact, and how we can save money.
Let’s dive right in:
Net Investment Income Tax (NIIT)
The net investment income tax is imposed on investment income if the modified adjusted gross income (adjusted gross income + foreign income exclusion) is more than $200,000 for single filers or $250,000 for those married filing jointly.
This tax is applied to the lower of:
- Net investment income
- Modified adjusted gross income above the threshold
Example
Say you have a modified adjusted gross income of $220,000. Your net investment income is $40,000. You are single. How much tax will you pay?
$220,000 – $200,000 = $20,000 (above the threshold)
The amount subject to the tax is the lesser of:
- $20,000 (income above the threshold), or
- $40,000 of net investment income
$20,000 * 0.038 = $760 of tax
Common examples of investment income
- Gains from the sale of stocks, bonds, and mutual funds
- 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 (qualified and ordinary)
- Interest
Note that the NIIT does not apply to:
- W-2 wages
- Self-employment income
- Social Security
- Distributions from retirement accounts (401(k), IRA, Roth)
- Income from an active trade or business
Now let’s talk about how we can save some money on taxes:
1. Interest
Municipal bond interest (received from a city or state) is tax-exempt. So, if you have a lot of interest income, consider shifting that portion of your portfolio to a municipal bond ETF and avoid the NIIT.
However, you still need to do the math to make sure it’s worth it.
Make sure the yield * (1 – marginal tax rate) is lower than the municipal bond yield. Remember. the goal is not to minimize taxes. The goal is to maximize your after-tax return.
2. Dividends
Dividends count toward the 3.8% NIIT. This applies to both qualified and ordinary dividends.
If you want to minimize the impact of NIIT, you can rebalance the portfolio to emphasize growth stocks over dividend-paying stocks. That said, make sure your overall asset allocation and risk tolerance are not compromised just to save on taxes.
Where possible, holding higher-dividend investments inside tax-advantaged accounts can also reduce exposure.
3. Capital gains timing & tax-loss harvesting
Capital gains increase net investment income, which can trigger or increase NIIT.
Some planning ideas:
- Realize gains in lower-income years, if possible
- Offset gains with harvested losses
- Avoid unnecessary fund turnover in taxable accounts
- Lower net investment income means lower exposure to the 3.8% tax
- Lower your adjusted gross income
4. Lower your adjusted gross income
If you stay below the income threshold, you don’t pay the net investment income tax at all.
Make sure you’re taking advantage of accounts that lower your income, such as:
- 401(k), 403(b), 457(b)
- SEP IRA
- Traditional IRA (if meet income threshold and/or no workplace retirement plan)
- HSA
This helps reduce your regular income tax and the potential NIIT.
5. Installment sales
If you can, spreading the gains from the sale of an investment property over multiple years may reduce the impact on your taxable income and limit how much of the gain is subject to the NIIT in any one year.
6. 1031 exchange
If you own investment real estate, a 1031 like-kind exchange can defer capital gains and reduce the immediate impact of the NIIT.
This doesn’t eliminate the tax forever, but it can significantly improve cash flow and tax efficiency.
Final thoughts
The net investment income tax often gets overlooked, but for higher earners, it can add thousands of dollars to the tax bill without you even knowing.
A few small planning decisions, like asset location, income timing, and account contributions, can make a difference over time.
I hope you enjoyed this one. If you have any content ideas, reply back to this email!
Chat next Saturday.