The Net Investment Income Tax
August 25, 2020
By Timothy Speiss
Funding the ACA/PPACA Medicare Taxes: The Net Investment Income Tax (“NIIT”)
The NIIT was legislated as part of the Health Care and Education Reconciliation Act of 2010. It went into effect on January 1, 2013. Along with the ACA, this Act reformed the health care market by requiring individuals to obtain health insurance or pay a tax penalty.
The NIIT was a revenue raiser in that legislation. The Joint Committee on Taxation estimated that together with the additional Medicare Tax, the NIIT would generate billions in tax revenue in 2013, the first year that this surtax would be in effect.
Who Is Subject to the NIIT
The NIIT is imposed on estates and trusts as well as individuals. For individuals, it applies to U.S. citizens and resident aliens. It does not apply to non-resident aliens unless they've elected to be treated as a resident of the U.S. for tax purposes so they can file joint married tax returns.
The NIIT applies to estates and trusts when their adjusted gross incomes for the year exceed the dollar amount at which the highest tax bracket begins. Grantor trusts and trusts that are exempt from income taxes, such as charitable remainder trusts, are exempt from the NIIT. In most cases, taxes on grantor trusts trickle down to and are payable by the individual—the grantor—who formed and maintains them.
Net Investment Income Defined
NII can be capital gains, interest, or dividends. It can include income produced by rental properties, capital gain distributions from mutual funds or the sale of investment property, and even royalty or annuity income and interest on loans you may have extended to others. It includes the income derived from a trade or business that is classified as passive income and income from business trading financial instruments or commodities. There are some exceptions.
Tax-exempt interest is not included in net investment income. Gains realized from the sale of a personal residence are spared as well when the gains are excluded from income for income tax purposes. Gains on property held in a trade or business are also exempt.
Net investment income does not include wages, self-employment income, unemployment compensation, Social Security benefits, or alimony.
The Basics of the NIIT
The net investment income tax thresholds for 2020 are $200,000 if you're single or file as head of household, $250,000 if you're married and filing jointly, or $125,000 if you're married filing separately. These amounts aren't indexed for inflation. They can increase in future years but they won't unless Congress specifically changes them through new legislation.
The NIIT is imposed in addition to your federal income tax. It's also over and above what you paid into Medicare through withholding from your earned income or estimated tax payments. But you're only subject to this tax if you have net investment income and your Modified Adjusted Gross income (MAGI) exceeds these thresholds.
The NIIT begins with the calculation of your MAGI. Start with your adjusted gross income, and add back some of the deductions you took to arrive at this number, including:
- Student loan interest, qualified tuition expenses, and the tuition and fees deduction
- The deduction for half your self-employment taxes
- IRA contributions
- Taxable Social Security payments
- Rental losses Passive loss or passive income
- Adoption expenses exclusion
- U.S. savings bond income exclusion
- Losses from a publicly-traded partnership
Taxpayers who invest in controlled foreign corporations and passive foreign investment companies might need to make further modifications to their adjusted gross incomes. If you derive any income from these sources and your MAGI exceeds the threshold for your filing status, you might want to consult with a tax professional to make sure your calculations are correct.
If your NII is less than the portion of your MAGI over the tax thresholds, you would pay 3.8% of this amount instead. Therefore, you have to compare your MAGI to your net investment income for the year. Remember, this is net income; therefore trade commissions or fees are deducted from your realized amount of net investment income. You can subtract expenses you incurred to maintain these investments such as tax preparation fees. Additional deductions that can reduce NII include:
- Deductions related to producing rental and royalty income
- Deductions related to producing business income
- Penalty on early withdrawal of savings
- Investment interest expenses
- Miscellaneous investment expenses
- The portion of state income tax that relates to net investment income
- Casualty and theft losses related to property that was sold or disposed.
Some of these deductions are already included in the investment income figures. For example, rental income, royalty income, business income, and net capital gains will already be a net amount after deductions or losses have been taken into account.
Other deductions, however, are not included in these net figures, so they must be deducted against investment income to arrive at net investment income. These separate deductions include the penalty on early withdrawal of savings, investment interest, investment expenses, state income tax allocated to investment income, and casualty and theft losses related to investment property.
The net investment income tax is due on the lesser of your net investment income or the portion of your MAGI that exceeds the thresholds. Multiply the applicable number by 3.8%.
Where Does the NII Tax Revenue Go?
The official name of the net investment income tax is the "Unearned Income Medicare Contribution Tax." This suggests that the tax revenue is used to fund Medicare, but the revenue raised by this tax actually goes into the nation's General Fund.
In their summary of the NII Medicare surtax, the Joint Committee on Taxation points out that "no provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund." In its preamble to the regulations, the IRS stated, "Amounts collected under Section 1411 are not designated for the Medicare Trust Fund."
File IRS Form 8960 with your tax return if you're subject to the net investment income tax. The form comes complete with instructions to help you determine what you owe, and it should be used by both individuals and estates and trusts. Keep in mind that if you owe this tax, the IRS expects you to make quarterly estimated payments on the amount you think you'll owe.
In PPACA's companion legislation, the Health Care and Education Reconciliation Act of 2010, an additional tax of 3.8% was applied to unearned income, specifically the lesser of net investment income and the amount by which adjusted gross income exceeds the above income limits.
PPACA includes an excise tax of 40% ("Cadillac tax") on total employer premium spending in excess of specified dollar amounts (initially $10,200 for single coverage and $27,500 for family coverage) indexed to inflation. This tax was originally scheduled to take effect in 2018, but was delayed until 2020 by the Consolidated Appropriations Act, 2016. Excise taxes totaling $3 billion were levied on importers and manufacturers of prescription drugs. An excise tax of 2.3% on medical devices and a 10% excise tax on indoor tanning services were applied as well.