What is the NIIT? It sounds like some sort of federal agency or maybe a new form of artificial intelligence. But actually NIIT stands for “net investment income tax.” This tax generally applies to higher-income taxpayers, but it could easily sneak up on others if they are not careful.

Background: The NIIT is equal to 3.8% of the lesser of your net investment income (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds an annual threshold of $200,000 for single filers and $250,000 for joint filers. Significantly, these figures are not indexed for inflation, so the reach of the NIIT extends as your income increases over time. The tax is also imposed on trusts and estates with income above the threshold based on the dollar amount of the highest tax bracket.

For this purpose, the definition of NII includes interest and dividends; distributions from annuities (other than tax-deferred distributions); rent and royalties; gains from investments in passive activities; trades of financial instruments and commodities; and net capital gain from the sale of property (other than property held in an active trade or business). In other words, much of your regular investment income probably falls into this category.

However, NII does NOT include salary or wages; distributions from IRAs and qualified retirement plans; taxable Social Security income; active trade or business income; self-employment income; gain on the sale of active interests in a partnership, S corporation or limited liability company; income from tax-exempt municipal bonds; and tax-deferred income from nonqualified annuities. So there is some tax relief.

Here are three examples showing when you may or may not owe this stealth tax.

  • You are a single filer with NII of $25,000 in 2023. At tax return time, it is determined that your MAGI is $250,000. Because the NII of $25,000 is less than the excess MAGI of $50,000, you owe a tax of $950 (3.8% of $25,000).
  • You are a single filer with NII of $40,000 in 2023. At tax return time, it is determined that your MAGI is $220,000. Because the excess MAGI of $20,000 is less than the NII of $40,000, you owe a tax of $760 (3.8% of $20,000)
  • You are a joint filer with NII of $100,000 in 2023. At tax return time, it is determined that your MAGI is $225,000. Because the MAGI does not exceed the $250,000 threshold, you do not owe the tax.

If you have already exceeded the NII threshold for 2023, there is not much you can do about it now. However, if you still have some flexibility, consider various strategies for reducing NII and/or MAGI, including postponing large capital gains, selling real estate on the installment basis, investing in tax-free municipal bonds, converting assets in a traditional IRA to a Roth IRA in a low tax year or using a charitable remainder trust (CRT), just to name a few.

Practical advice: Coordinate one or more of these strategies with assistance from your JMF professional advisors. They can help you maximize investment earnings at the lowest tax cost.