Net Investment Income Tax 101

By Team HRH | January 5, 2015

The following article was written for our newsletter sent to financial advisors.

The Net Investment Income Tax is new for tax year 2013. This tax is intended to apply to higher-income individuals who derive part of their income from investments. Financial advisors who are familiar with the following NII tax issues may provide invaluable assistance to their clients:

  • Net Investment Income (NII)
  • Modified Adjusted Gross Income (MAGI)
  • Individuals
  • Determining the tax
  • Estates and Trusts


NET INVESTMENT INCOME

The general rule is that NII includes interest, dividends, capital gains, annuities, royalties, and rents, as long as they are not derived in the ordinary course of an active trade or business of the taxpayer. NII includes income derived from a trade or business if that trade or business is a passive activity with respect to the taxpayer (ex. Publicly traded partnerships), or trading in financial instruments or commodities (ex. Hedge funds). NII generally does not include income from an active trade or business, gain from the sale of an active trade or business, distributions from IRAs or qualified retirement plans, stock-bonus plans, and income subject to self-employment tax.

MODIFIED ADJUSTED GROSS INCOME

MAGI is the sum of the taxpayer’s Adjusted Gross Income (found at the the bottom of the first page of your client’s 1040) and any foreign earned income that your client elected to exclude from gross income if they lived abroad. The tax compares NII to the excess of MAGI over a threshold. The threshold is $250,000 for clients who are married filing joint, $125,000 for married filing separate, and $200,000 for all others.

INDIVIDUALS

For individuals, the NII tax imposes a 3.8% tax on the lesser of NII, or the excess of MAGI over a threshold amount. The rules of this tax can get complicated quickly, but there are two important things to remember. The first is that if your client has no NII, then your client will not pay this tax. The second is that if your client’s MAGI is not over the threshold, then your client will not pay this tax.

DETERMINING THE TAX

The following are four examples to illustrate the computation of the tax:

(1) Phil files as a single taxpayer with MAGI of $220,000 and NII of $100,000. The excess of his MAGI ($220,000) over the threshold ($200,000) is $20,000. Phil’s excess of $20,000 is less than his NII of $100,000. 3.8% of $20,000 is $760. Phil pays tax of $760.

(2) Joe files a joint return with his spouse. They have MAGI of $400,000 and NII of $100,000. The excess of their MAGI ($400,000) over the threshold ($250,000) is $150,000. Their NII ($100,000) is less than their excess ($150,000). 3.8% of $100,000 is $3,800. Joe pays tax of $3,800.

(3) Bob files as a single taxpayer with wages of $150,000, dividends of $25,000, and active business income of $150,000. The excess of his MAGI ($325,000) over the threshold ($200,000) is $125,000. Bob’s NII ($25,000) is less than his excess ($125,000).  3.8% of $25,000 is $950. Bob pays tax of $950.

(4) Molly files a joint return with her spouse. They have MAGI of $250,000 and NII of $250,000. The excess of their MAGI ($250,000) over the threshold ($250,000) is zero.  Their excess of zero is less than their NII ($250,000). Molly pays no tax.

ESTATES AND TRUSTS

The NII tax also applies to estates and trusts. The formula for determining the tax is different from individuals. The rate of 3.8% is unchanged, but it is applied to the lesser of the undistributed net investment income for the tax year, or the the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins ($11,950 in 2013). As a practical matter, distributing all of the NII from an estate or trust would mean no surtax for the estate or trust. Since individuals have a much higher threshold before they have to pay the tax, distributing all of the NII from an estate or trust is a potential tax planning strategy.

This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation. Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business. 

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