Planning for the New Net Investment Income Tax

December 2013
Author:  Robert Conner

Robert Conner



Health Care
Manufacturing & Distribution

1801 California Street, Suite 2900
Denver, CO 80202-2606


Much of the hype surrounding the Patient Protection and Affordable Care Act (ACA) centers on insurance coverage requirements and the related “play or pay” implications of the employer mandate provision. A lesser-known provision of ACA adds Chapter 2A to the Internal Revenue Code, which requires certain higher-income taxpayers to pay a new 3.8 percent surtax on net investment income beginning in 2013. Contrary to popular belief, the new net investment income tax (NIIT) is not a Medicare tax, as amounts collected under the NIIT are not designated for the Medicare trust fund. This new tax is not deductible like one half of the Medicare tax; it’s subject to estimated tax provisions.

This article examines how the new 3.8 percent NIIT applies to individuals, estates and trusts, as well as exploring planning strategies that may help mitigate its impact.


Individual taxpayers (excluding nonresident aliens) are subject to an additional 3.8 percent NIIT on the lesser of:

  • The individual’s net investment income
  • The excess (if any) of the individual’s modified adjusted gross income (MAGI) over an applicable threshold

MAGI typically will be the same as adjusted gross income (AGI). However, taxpayers with foreign earnings excluded from taxable income may be required to make certain adjustments.

The applicable threshold is $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately and $200,000 for all other taxpayers. These threshold amounts are not indexed for inflation.

Example 1 – Dylan, a single taxpayer, has $100,000 of salary income, $90,000 of net investment income and $190,000 of MAGI. The 3.8 percent NIIT would not apply, as Dylan’s $190,000 of MAGI is less than the $200,000 threshold amount for single taxpayers.

Example 2 – Kevin and Beth, married taxpayers filing a joint return, have $200,000 of salary income, $100,000 of net investment income and $300,000 of MAGI. The 3.8 percent NIIT would apply to $50,000 (their MAGI of $300,000 less their $250,000 threshold), which is less than their net investment income of $100,000.

Estates & Trusts

Estates and certain trusts are subject to an additional 3.8 percent NIIT on the lesser of:

  • The estate’s or trust’s undistributed net investment income
  • The excess (if any) of the estate’s or trust’s AGI over the dollar amount at which the highest tax bracket begins for the year

The 3.8 percent NIIT is of particular concern to estates and trusts, since the highest tax bracket for estates and trusts begins at a relatively low income level—$11,950 for 2013.

Example 3 – The Taylor Trust pays income and principal as needed to its beneficiary, a single individual whose only other source of income is municipal bond interest income. In 2013, the trust makes no distributions and has undistributed net investment income of $150,000 of dividend income. The trust’s AGI for the year is $150,000. The 3.8 percent NIIT would apply to $138,050 ($150,000 of AGI less the $11,950 amount at which the highest tax bracket begins for the year), as this is less than the trust’s undistributed net investment income of $150,000.

Example 4 – If, in the preceding example, the trust distributed $100,000 of dividend income to the beneficiary, the 3.8 percent NIIT would apply to $38,050. The beneficiary is not subject to the NIIT on the $100,000 of dividend income—the threshold for a single taxpayer is $200,000 and the municipal bond interest income is specifically excluded from the definition of net investment income.

Net Investment Income

Taxpayers with MAGI over the applicable threshold are required to compute their net investment income in order to determine the 3.8 percent surtax. Certain items are specifically excluded from net investment income, including wages, self-employment income IRA distributions and other qualified retirement plan distributions.

Most items of unearned income will not escape the net investment income clutches. Net investment income specifically includes the sum of the following:

  • Gross income from interest, dividends, annuities, royalties and rents, unless derived in the ordinary course of a nonpassive, nontrading trade or business
  • Other gross income from a trade or business that is a passive activity to the taxpayer or a trade or business of trading in financial instruments and commodities
  • Net gain (to the extent taken into account in computing taxable income) from the disposition of property other than property held in a nonpassive, nontrading trade or business

The following is then subtracted from the sum:

  • Deductions properly allocable to such gross income or net gain

Properly Allocable Deductions – Gross income from rents, royalties and trades or businesses that make up net investment income are reduced by deductions allocable to such income. Properly allocable deductions also include several itemized deductions, such as investment interest expense, investment expenses and state income taxes imposed on investment income, but only after application of the 2 percent floor on miscellaneous itemized deductions and Pease limitation.

Trade or Business Exception – Net investment income generally does not include income or gains derived in the ordinary course of a nonpassive, nontrading trade or business. However, gross income and net gain attributable to the investment of working capital is considered net investment income, as it is not derived in the ordinary course of a trade or business. So owners of nonpassive businesses using investment accounts or interest-bearing accounts to park extra funds should be conscious of this working capital inclusion.

Activity Groupings – The enactment of the NIIT may cause taxpayers to reconsider previous activity grouping determinations. Therefore, taxpayers are given a one-time opportunity to regroup activities in the first year in which the taxpayer has MAGI in excess of the threshold and has net investment income. This is of particular importance to taxpayers who have multiple activities and find it difficult to meet the material participation standards necessary to be considered nonpassive with respect to their activities.

Net Gains – The amount of net gain included in net investment income may not be less than zero. However, taxpayers are permitted to include up to $3,000 of capital losses in excess of capital gains as a properly allocable deduction when computing net investment income. To the extent a taxpayer has certain loss carryforwards, those losses may offset net investment gains in the tax year they affect adjusted gross income, e.g., capital loss carryforward or investment interest expense carryforward.

Net gains included in AGI from the sale of publicly and privately held C corporation stock always are considered net investment income. However, taxpayers who sell an interest in a nonpassive, nontrading partnership or S corporation will need to perform a detailed analysis to determine if an adjustment to gain or loss is required for purposes of computing net investment income.

Often, this adjustment will exclude some or all of the gain from net investment income.

Planning Considerations

The 3.8 percent NIIT only applies if a taxpayer has net investment income and MAGI in excess of the applicable threshold. Therefore, the following planning considerations revolve largely around strategies intended to properly time and control MAGI and net investment income.

Investments, Gains & Losses

Planning Tip #1 – Taxpayers may want to rebalance their investment portfolio to emphasize growth assets over dividend-paying assets. Taxpayers also may want to consider favoring investments in tax-exempt bonds, as tax-exempt interest and dividends would not be included in MAGI or net investment income. Taxpayers considering this strategy should work with their tax and investment advisors to determine if the rebalanced portfolio works with their overall wealth plan strategy.

Planning Tip #2 – Due to the expiration of the Bush-era preferential rates on capital gains coupled with the NIIT, taxpayers should consider gain deferral options such as installment sales and like-kind exchanges.

These strategies would require analyzing many tax and nontax factors such as cash flow needs, anticipated future tax rates and time value of money.

Planning Tip #3 – Consider donating appreciated securities rather than cash to charity. Doing so will generate a charitable deduction equal to the fair market value of the security, avoid capital gains tax on the built-in gain of the security and avoid the 3.8 percent Medicare surtax on the gain. Taxpayers then could use the cash they would have otherwise donated and repurchase the security to achieve a step-up in basis. Taxpayers considering this strategy should be mindful of itemized deduction limitations that could defer a portion of the charitable deduction to a later tax year.

MAGI Planning

Planning Tip #1 – Taxpayers with MAGI approaching the threshold should carefully consider timing the payment of bonuses, commissions, nonqualified stock options and other forms of compensation.

Planning Tip #2 – Consider converting traditional IRAs to Roth IRAs in years when MAGI is below the threshold. Doing so allows future account earnings to grow tax-free and eliminates the need to make required minimum distributions.

Trade or Business Activity Planning

Planning Tip #1 – Revisit converting an active trade or business to an S corp. S corp owner earnings in excess of amounts paid out as reasonable compensation will not be subject to the 3.8 percent net investment income tax, the 0.9 percent Medicare tax on high-income earners or self-employment tax.

Planning Tip #2 – Review your current grouping elections. Taxpayers with multiple activities often find it difficult to meet the material participation standards necessary to be considered nonpassive with respect to their activities. In light of the new NIIT, taxpayers can regroup activities that represent an appropriate economic unit for purposes of measuring material participation. Passive activity planning is a complicated tax area and should be discussed with your tax advisor.

Estate & Trust Planning

Planning Tip #1 – Consider the benefit of distributing income to beneficiaries. Certain trusts and estates will be subject to the 3.8 percent Medicare surtax to the extent that undistributed net investment income exceeds a relatively low threshold—$11,950 for 2013. On the other hand, beneficiaries have a much higher threshold for purposes of imposing the tax. Therefore, it may make sense for fiduciaries to distribute the net investment income where the discretion to do so exists.

Planning Tip #2 – Consider using family limited partnerships to spread investment income among family members or consider gifting appreciated or dividend paying securities to children. While the children likely will still pay federal income tax on income from these assets at their parent’s rates, the children will not pay the 3.8 percent net investment tax unless they have MAGI over their applicable threshold.


The new 3.8 percent NIIT, coupled with the 4.6 percent increase in the top marginal tax rate and the return of the Pease limitation on itemized deductions and personal exemption phaseouts, could mean higher-income taxpayers will face a 10 percent year-over-year tax increase in 2013. In light of these tax rate increases, taxpayers must educate themselves on available options, evaluate planning strategies under an array of different possibilities and make the most informed decision possible with respect to a course of action.

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