There’s a Stealth Tax retirees and near-retirees often don’t know about until they inadvertently trigger it, costing them a lot of taxes that often could have been avoided or reduced.
Many taxpayers who pay this Stealth Tax aren’t subject to it every year. Instead, a change in their finances activates the tax. Many people don’t learn about the tax until their income tax returns are prepared.
This least-known Stealth Tax, the net investment income tax (NIIT), was created in the Affordable Care Act and labeled as a Medicare surtax, though the proceeds go into general revenues.
The NIIT is an additional 3.8% tax on investment income, also known as unearned income, when modified adjusted income (MAGI) exceeds certain amounts. For example, when you’re subject to the NIIT, the maximum tax on long-term capital gains can jump from 20% to 23.8%.
The NIIT is imposed on single taxpayers with modified adjusted gross income (MAGI) exceeding $200,000 and married couples filing jointly with MAGI above $250,000.
More and more taxpayers owe the NIIT each year, because the income thresholds aren’t indexed for inflation. As income and gains climb with inflation, higher market returns, and more valuable portfolios, you’re more likely to trigger the NIIT.
MAGI for this tax is your regular adjusted gross income (AGI) plus any foreign earned income that qualified for the exclusion from gross income.
Unearned, or investment, income includes interest, dividends, capital gains, annuity distributions (taxable distributions only and only when not from a qualified retirement plan), royalties, and passive real estate rental income. Income from a trade or business is included if it is a passive activity for you.
The NIIT doesn’t apply to tax-exempt interest, Veterans Administration benefits, or any gain from the sale of a principal residence that’s excluded from gross income.
Distributions from IRAs, 401(k)s, and other qualified retirement plans also don’t count as investment income for the tax.
To compute the NIIT, add all the investment income for the year. Then, subtract all investment-related expenses to arrive at net investment income.
The 3.8% NIIT is imposed on the lesser of net investment income and the amount of MAGI above the income threshold.
Suppose Max and Rosie Profits have net investment income of $30,000 and MAGI of $270,000. The excess of MAGI over the income threshold ($250,000 for a married couple filing jointly) is $20,000. That’s lower than their net investment income of $30,000. So, the NIIT for them is 3.8% of $20,000, or $760.
Suppose instead the Profits’ MAGI is $290,000 and net investment income still is $30,000. The difference between MAGI and the threshold is $40,000. Net investment income is less than that and will be the basis of the tax. So, the tax would be 3.8% of $30,000, or $1,140.
Capital gains and qualified dividends are included in net investment income, so the NIIT effectively increases the maximum tax rate on those tax-advantaged sources of income.
One trick to the NIIT is that all sources of income increase your MAGI and potentially trigger the tax, but only the investment income is subject to the tax. Because of that, making financial moves unrelated to investment income can trigger the NIIT.
For example, you take an additional traditional IRA distribution to pay unexpected expenses. IRA distributions aren’t subject to the surtax. But the distribution will increase your MAGI and could push you from an income level that is exempt from the surtax into one that triggers the surtax on all your unearned income.
Here are strategies to avoid paying the NIIT on investment income either in the current year or future years.
Consider the NIIT before taking significant capital gains. The gains increase your MAGI and could push you into the NIIT. Plus, the gains themselves will be subject to the NIIT. Alternatives are to spread the gains over several years or search your portfolio for losses to offset some of the gains.
Business owners need to realize the surtax often will apply to the sale of a business. That’s an extra 3.8% tax in addition to the other taxes and the costs of selling.
Tax-exempt bonds. When your income is high enough to trigger the surtax regularly, shifting some income investments to tax-exempt bonds instead of other income vehicles could both lower your MAGI and avoid or reduce the surtax.
Convert traditional IRAs to Roth IRAs. Distributions from traditional IRAs and pensions are exempt from the surtax, but they increase your MAGI and can trigger the surtax on your investment income.
When traditional retirement plan distributions combined with your other income are likely to trigger the surtax on a regular basis, you could reduce taxes in the long term by converting all or part of traditional IRAs to Roth IRAs. Roth IRA distributions are not included in MAGI. Be sure to consider this factor when deciding whether or not to convert all or part of a traditional IRA.
Keep in mind, however, that in the year of conversion the amount converted will be included in your MAGI and could trigger the surtax that year.
Review deferred compensation strategies. A classic tax strategy is to defer income and taxes, especially on compensation. You might want to reconsider such strategies. The deferred compensation will be included in MAGI and could trigger the NIIT in later years.
Reduce AGI. Almost everything that decreases your AGI also decreases MAGI and helps avoid or reduce the NIIT. Strategies for reducing AGI are discussed in our April 2024 issue.
NIIT is computed and reported separately on Form 8960, which should be included with your Form 1040.