As you’re probably aware, creating a comfortable retirement isn’t necessarily just about how much money you’ve saved and invested, it’s about how much income you can create from your retirement savings and other resources like Social Security and pensions.
If you anticipate being a high-income retiree — which we’ll call $200,000 or more from all income sources combined — there’s an additional tax that you might have to plan for. It’s called the net investment income tax, or NIIT, and it can add thousands of dollars to the tax bills of certain households, both before and after retirement.
The net investment income tax
The net investment income tax, also sometimes referred to as the Medicare surtax, went into effect for the 2013 tax year. It is applied at a rate of 3.8% to the net investment income of certain high-income households, estates, and trusts.1 (We’ll get into what counts as “net investment income” later on.)
The NIIT applies to people who have any net investment income at all and a modified adjusted gross income (MAGI) over these thresholds:
- Single or head of household: $200,000
- Married filing jointly or qualifying widow(er) with dependent child: $250,000
- Married filing separately: $125,000.2
Because these income thresholds are not indexed to inflation, the NIIT has been applying to more people over time. In fact, according to The Wall Street Journal, revenue from the NIIT has more than tripled since it took effect in 2013, and the number of taxpayers who have to pay it has increased from about 3 million to 7 million. Unless Congress decides to index the income figures for inflation, both the revenue and the number of taxpayers who owe the NIIT are likely to continue to rise.³
Now, the NIIT is not the same thing as the Additional Medicare Tax, which increases the standard Medicare tax rate by 0.9 percentage points for high-income individuals whose earned income exceeds a certain amount.4 However, both taxes went into effect at the same time and have the same purpose — to offset the costs of the Affordable Care Act on the Medicare program. The big difference is the NIIT applies to investment income while the Additional Medicare Tax applies to earned income.
Good news and bad news
First, the good news. The net investment income tax only applies to investment income. Because distributions from retirement accounts like IRAs and 401(k)s are generally treated as ordinary income for tax purposes — or are not treated as taxable income at all in the case of Roth accounts — the net investment income tax doesn’t apply to them.
If 100% of your assets are in tax-advantaged retirement accounts, you’re home free (at least when it comes to the NIIT). But if you’re like most high-net-worth investors, you have some combination of retirement accounts and taxable investment accounts. Interest-bearing bank accounts like CDs are also becoming far more prevalent among pre-retirees and retirees thanks to the rising-rate environment, and interest income counts as investment income by the IRS’s definition. And this is where the bad news comes in.
The bad news for most high-net-worth investors is in how the NIIT is triggered. Recall from the previous section that the NIIT kicks in for individuals who have modified AGI in excess of the corresponding income threshold for their tax filing status, and have any net investment income at all. In other words, even if your “investment income” is $1,000, if your modified AGI is high enough, the net investment income tax will apply to that $1,000.
In other words, because the threshold for where the NIIT kicks in is based on your total income, income from retirement distributions and other sources of income to which the NIIT doesn’t apply can put you over the threshold. This would make even smaller amounts of other investment income subject to the tax.
Example of the net investment income tax
As a simplified example, let’s say that you’re single and have $150,000 in annual distributions from retirement accounts, and $50,000 of net income from a small business you help operate. Neither of these types of income are subject to the 3.8% net investment income tax. However, the threshold of where the NIIT can be applied for a single individual is $200,000,5 so these sources of income would put you in the NIIT category.
Now let’s say that you also have some investments in a standard brokerage account from which you receive $30,000 in dividend and interest payments. Because your total income is in NIIT territory, the 3.8% tax could apply to this $30,000, even though most would agree this isn’t exactly a high level of investment income. At the 3.8% rate, the NIIT would add $1,140 to your tax bill, and that’s on top of the federal income taxes you’d also have to pay on your dividend and interest income.
Of course, every situation is different. Above-the-line tax deductions like student loan interest and alimony payments could keep the MAGI below the net investment income tax threshold.
What is and isn’t counted as net investment income?
So, what counts as net investment income? According to the IRS definition, investment income includes (but isn’t necessarily limited to):
- Interest income
- Dividends
- Capital gains
- Rental income
- Royalties
- Non-qualified annuities
- Income from a business you are not actively involved in6
It’s also worth pointing out that the tax is called the net investment income tax. This means that if you have investment losses, they can be used to offset your investment income for the purposes of the NIIT. For example, if you sell a stock at a $10,000 profit and sell another at a $4,000 loss, you’d have a $6,000 overall capital gain for the purposes of computing your net investment income.
A notable exception to what counts as net investment income is the gain on the sale of a primary residence, as long as the gain is less than $250,000 (or $500,000 for a couple filing jointly). This is known as the primary residence exclusion and is a completely tax-free gain for those who meet the residency requirements.7
Although the list of what counts as net investment income is long, it doesn’t encompass all earned income. Wages, salaries, and tips, as well as income from a business you play an active role in, are all earned income, but not net investment income. Social Security income is also not counted, nor is tax-exempt interest, self-employment income, or qualified retirement plan distributions, as discussed earlier.
How you can lower your net investment income tax
There are certainly some strategies you can use in retirement to reduce or avoid the NIIT altogether. For one thing, you could consider withdrawing more heavily from your taxable brokerage accounts in years when your total income is lower, and more lightly in years when your overall income is higher. Or, you could consider donating appreciated securities to charity instead of selling them and donating cash, as the former strategy won't trigger the tax.
Another possible strategy is to look into investments that are exempt from the NIIT, such as tax-free bonds, as opposed to taxable fixed-income investments. When withdrawing money from your taxable brokerage account to provide income, you might consider a tax-loss harvesting strategy if you have any losing investments.
Every situation is different, so if you have a relatively high level of total income, which the NIIT defines as $200,000 or more for single or head of household filers, or $250,000 for couples filing jointly, it is always a good idea to discuss the potential implications of NIIT or any other tax decisions with an experienced tax professional.
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