Net investment income tax: how does it affect you?

• Author: Varjabedian, Chris

The net investment income tax imposed by Sec. 1411 is a 3.8% tax on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount, which is discussed later. Under Sec. 1411(d), MAGI is defined as adjusted gross income increased by the amount excluded from gross income under Sec. 911(a)(1) (the foreign earned income exclusion) over the amount of deductions or exclusions disallowed under Sec. 911(d)(6) (denial of a double tax benefit from excluded foreign earned income). The net investment income tax went into effect for tax years beginning on or after Jan. 1,2013, and is more likely to affect wealthier individuals, but can also affect individuals of more moderate means who have a spike in income in a particular year.

Investment income for purposes of the net investment income tax includes:

* Annuity distributions;

* Dividends;

* Income from passive activities;

* Interest and net gain, to the extent taken into account in computing taxable income, from the disposition of property other than property held in a trade or business to which the net investment income tax does not apply;

* Rents; and

* Royalties.

Income such as salaries and wages, IRA distributions, self-employment income, gain on sale of an active interest in a partnership or S corporation, capital gains from the sale of a principal residence excluded under Sec. 121, tax-exempt interest, and veterans benefits are excluded.

As noted above, the net investment income tax applies to an individual taxpayer only when the taxpayer's MAGI exceeds a threshold amount. The thresholds for each type of affected taxpayer are as follows:

* Single: $200,000;

* Married filing jointly: $250,000; and

* Married filing separately: $125,000.

Other Ways to Minimize Net Investment Income Tax

Taxpayers can avoid the net investment income tax by avoiding income that is subject to the tax and by keeping their MAGI below the applicable threshold amount. Ways to achieve these goals include:

Roth IRA conversions: Withdrawals from Roth IRAs, unlike withdrawals from traditional IRAs and qualified plans, are not includible in MAGI for purposes of the...