What is the Net Investment Income Tax, and how is it calculated?

Abram Claude, Vice President, Columbia Management Learning Center | September 18, 2013

  • The Net Investment Income Tax is a new, permanent tax that is effective beginning in 2013.
  • Investors who break a certain modified adjusted gross income threshold may face a 3.8% surtax. This tax is in addition to any ordinary income or long-term capital gains tax obligations.
  • The Columbia Management Learning Center is dedicating a series of blog articles to this important and timely “Navigating the New Tax Regime” topic.

The net investment income tax is a new, permanent tax that is effective beginning in 2013. The tax will go into the general revenue of the U.S. Treasury, but it was legislated to support the Affordable Care Act of 2010. Investors who hold taxable fixed-income securities in taxable accounts, including trust accounts, may be among the most affected by this new tax.

For individuals, the 3.8% surtax impacts those with modified adjusted gross income over certain thresholds, which are $200,000 for single filers and $250,000 for joint filers. For the purposes of net investment income tax, modified adjusted gross income = adjusted gross income + certain excluded adjusted foreign earned income.

The 3.8% tax is in addition to any other tax paid at either the ordinary income rate, at the long-term capital gains rates, and the alternative minimum tax. For taxpayers subject to the net investment income tax and in the 33% income tax bracket, the effective rate for at least a portion of those dollars could be 36.8%. If subject to the 15% long-term capital gains rate, the effective rate on affected gains could be 18.8%.

The calculation of the net investment income tax is a two-step process. First, you calculate how much your modified adjusted gross income (MAGI) exceeds the threshold; then you determine the amount of net investment income earned for the year. The tax applies to the lesser of the two figures.

Example 1

Example 2

What is included under net investment income? Among income included is taxable interest, dividends, capital gains, rent, royalties and taxable distributions from non-qualified annuities. Income from a trade or business that is a passive activity (under the passive loss rules) is also included.

What is not included? Examples of income excluded are wages and compensation, distributions from qualified plans and IRAs and tax-exempt income such as municipal interest.

(Click the image below to enlarge:)

Calculating the Net Investment Income Tax

Remember that taxable interest earned in a taxable account is included under both MAGI and under net investment income. Taxable distributions from qualified plans and IRAs count under MAGI, but do not count under net investment income. Municipal interest generally does not count under MAGI nor does it count under net investment income.

There are steps that financial advisors and investors can take to potentially avoid crossing the threshold, or if they do cross the threshold, there are steps that could mitigate the degree to which the net investment income tax applies. In our next installment of the series, we will begin to examine some of those steps.

Next week in this series:

  • The power of the workplace in lowering modified adjusted gross income, net investment income or both
  • Maximizing workplace retirement plans to reduce or eliminate the net investment income tax

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