If your income hits a certain level, you may face an additional wrinkle in calculating your taxes: the net investment income tax (also referred to as the unearned income Medicare contribution tax).
This 3.8% Medicare tax applies to some or all of your net investment income if your modified adjusted gross income (MAGI) exceeds certain thresholds. The tax is in addition to any other income tax applicable to such income.
If the net investment income tax applies, your long-term capital gains and qualified dividends may be subject to a combined federal tax rate of as much as 23.8% (the top long-term capital gains tax rate of 20% + 3.8%). Your other taxable investment income may be subject to a combined federal tax rate of as much as 40.8% (the top regular income tax rate of 37% + 3.8%). Your investment income may also be subject to state income tax.
In general, the net investment income tax applies to U.S. individual tax-payers (similar rules apply to certain domestic trusts and estates).
CALCULATION OF NET INVESTMENT INCOME TAX
The net investment income tax is equal to 3.8% of the lesser of (a) your net investment income or (b) the excess of your MAGI over:
- $200,000 if your filing status is single or head of household
- $250,000 if your filing status is married filing jointly or qualifying widow(er) with dependent child
- $125,000 if your filing status is married filing separately
For purposes of the net investment income tax, MAGI is generally equal to your adjusted gross income (AGI).
You and your spouse file a joint tax return. Assume your net investment income is $50,000 and your MAGI is $270,000. The amount of your net investment income subject to this tax is equal to the lesser of (a) $50,000 or (b) the excess of $270,000 over $250,000, or $20,000. Your net investment income tax is equal to $20,000 x 3.8%, or $760.
NET INVESTMENT INCOME
Net investment income includes gross income from:
- Interest, dividends, nonqualified annuities, royalties, and rents that are not derived from the ordinary course of a trade or business, and
- Net gain from the disposition of property not used in a trade or business
Gross income and net gain (or loss) from a trade or business may be included in net investment income if the trade or business is (a) a passive activity or (b) engaged in trading financial instruments or commodities.
Net investment income does not include income excluded from gross income for income tax purposes. It also does not include items of gross income and net gain specifically excluded from net investment income. Examples of excluded items include:
- Wages
- Unemployment compensation
- Alimony
- Social Security benefits
- Tax-exempt interest income
- Income from certain qualified retirement plan and IRA distributions
- Self-employment income
- Gain that is not taxable on sale of a principal residence
Even though certain items such as wages and income from certain qualified retirement plan and IRA distributions may not be included in net investment income, they may be included in MAGI, which (as discussed above) is a factor in determining the amount of net investment income that is subject to the net investment income tax.
If the net investment income tax applies, your long-term capital gains and qualified dividends may be subject to a combined federal tax rate of as much as 23.8% (the top long-term capital gains tax rate of 20% + 3.8%).
PLANNING FOR THE NET INVESTMENT INCOME TAX
For a particular taxable year, the net investment income tax applies only if your MAGI exceeds the appropriate threshold based on your tax filing status. Also, the net investment income tax applies to the lesser of (a) your net investment income or (b) the excess of your MAGI over the appropriate threshold. So you may be able to reduce exposure to the net investment income tax by controlling the timing of items of income or deduction that enter into the calculation of net investment income or MAGI.
For example, you might consider increasing your net investment income in a year in which your MAGI does not exceed the threshold. Conversely, you might consider decreasing your net investment income in a year in which your MAGI exceeds the threshold.
RECORDKEEPING
Net investment income tax is reported on IRS Form 8960. If you owe net investment income tax, you must attach Form 8960 to your tax return.
CHRIS KELLY
CPA, CFP®, M.Accy
Financial Advisor, Senior Relationship Manager & Executive Manager
ckelly@bwfa.com