Tax Planning Strategies for the 3.8% Net Investment Income Tax

Tax Planning Strategies for the 3.8% Net Investment Income Tax

By Alan Olsen, CPA, MBA (tax)
Managing Partner
Greenstein Rogoff Olsen & Co. LLP

Anyone who has any kind of investment income has probably wondered how tax laws will affect that income. Investment income can vary and the tax laws differ as well. As with many tax laws, how much investment income you actually make will play a big role in how much you are taxed.

What, When, Who?

However, before we look at the details of how the Net Investment Income Tax (NIIT) works and the strategies to avoid it, let’s first answer a few important questions about the NIIT.

  • What is the NII Tax? – The NIIT is imposed by section 1411 of the Internal Revenue Code. The NIIT only applies to some net investment income at a 3.8 percent rate. It also only applies to people, trusts or estates that exceed the statutory threshold amounts.
  • When did it take effect? – The NIIT first went into effect at the beginning of 2013. Although it went into effect in 2013 it did not apply to the 2012 tax year.
  • Who is subject to the tax? – Not everyone is subject to the NII tax. Only those who exceed the thresholds amounts – which are listed later in this article – are subject to the NII tax. Also of note, the threshold amounts are not indexed for inflation.
What Qualifies as Net Investment Income?

Now let’s take a look at what type of income actually fits into the net investment income category. Net investment income includes the following:

  • Interest
  • Dividends
  • Annuity distributions
  • Rents
  • Royalties
  • Income from a passive activity
  • Net capital gain from the disposition of property

On the other hand, the following items are not considered net investment income:

  • Salary, wages & bonuses
  • Distributions from IRAs or qualified plans
  • Any self employment income
  • Gain on sale of active interest in a partnership or S Corp
  • Items which are otherwise excluded or exempt from income under the income tax law such as tax-exempt bonds
  • Capital gains excluded under IRC 121 and veteran benefits
How to Plan for the Net Investment Income Tax

There are several things you can do plan for this income tax, which may help lessen the blow. However, first and foremost you should understand that this tax, like many other taxes, mostly affects the wealthy. Those who make more than $200,000 a year will be hit with this tax and those who are considered extremely rich will see the biggest hit.

Planning Strategies

So let’s take a look at some of the strategies you can employ when it comes to the 3.8% Net Investment Income Tax:

Strategy 1: Focus on Threshold Amount – By staying under the threshold amount you can avoid this tax completely. For 2014, the 3.8 % tax applies to the lesser of: Lesser of Net Investment income or the excess (if any) or – Modified AGI less threshold amount. The threshold amounts are as follows:

  • Single-$200k
  • Married-$250k
  • Married (separate) $125k
  • Estates/Trusts $12,125

Strategy 2: Using Roth IRA conversions

Strategy 3: Using Installment sales

Strategy 4: Using Non-Grantor Charitable Lead Trust (CLTs)

Strategy 5: Using Charitable Remainder Trust (CRTs)

The next six strategies all focus on reducing your net investment income, which may help you escape the NIIT. You can do that by focusing on the following sources of income:

Strategy 6: Municipal bonds

Strategy 7: Tax deferred annuities

Strategy 8: Life insurance

Strategy 9: Rental real estate

Strategy 10: Oil and gas investments

Strategy 11: Timing of estate/trust distributions

GROCO Knows How To Help

The bottom line is that the IRS is always looking for more ways to collect on taxes and that’s especially true for the wealthy and extremely rich. By employing one or more of these strategies you might be able to avoid the 3.8% Net Investment Income Tax. If you need more help with planning for this tax or further explanation on any of these strategies, then contact us at GROCO. We can help you make the best choices for your investment income tax planning. Call us at 1-877-CPA-2006 or click here to contact us online.