The 3.8% Tax on Net Investment Income Demystified!

Many watching the fiscal cliff debacle with trepidation, heaved a sigh of relief when the number "$450,000" seemed to have been decided upon as the sign of those that are going to get hit by all the big taxes. However what many missed is the sneaky 3.8% "Obamacare Tax" that went into effect on Jan. 1st, 2013. 

The Net Investment Income Tax (NIIT) is imposed by Sec 1411 of the Internal Revenue Code (IRC). This tax applies at a rate of 3.8% on certain investment income of individuals, estates and trusts that have income over the statutory thresholds. 

The 3.8% surtax applies to the lessor of: 

• Net Investment Income (defined later) OR
• The excess of modified adjusted gross income (MAGI) over the thresholds,

                     Married Filing Jointly or Surviving Spouse: $250,000

                     Single or Married Filing Separately: $125,000

                     All Others: $200,000

Note that if you are an individual exempt from Medicare Taxes, you may still be subject to the NIIT if you have Net Investment Income and MAGI over the above thresholds.

What is Net Investment Income?   In general, investment income includes, but is not limited to: 

• interest, dividends, 
• rental and royalty income, 
• non-qualified annuities, 
• income from businesses involved in trading of financial instruments or commodities, 
• businesses that are passive activities to the taxpayer (within the meaning of IRC section 469),
• capital gains from sale of stocks; bonds; mutual funds; distributions from mutual funds; sale of investment real estate (including sale of second home not primary residence); sale of interests on partnerships and S corporations (to the extent you were a passive owner). 

To calculate your Net Investment Income, your investment income is reduced by certain expenses properly allocable to the income.

What is NOT Net Investment Income:  

Wages, unemployment compensation; operating income from a non-passive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends and distributions from certain Qualified Plans.

How Do You Report & Pay the NIIT?: 

For individuals, the tax is reported and paid on Form 1040 and for estates & trusts, the tax will be reported and paid on Form 1041. The NIIT is also subject to the Estimated Tax Provisions. (See post: Do I have to pay estimated taxes?) You can also request that your withholding from wages be increased if you are expecting to be hit with the NIIT. 

Update Posted on 08/07/2013 on the Buzz About Taxes Here.

Bibliography: 

1. Proposed Regulations Department of Treasury. 
2. Internal Revenue Service-FAQ's
3. AICPA January 2013 Update Seminar Materials

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Please read my disclaimer here. For more questions regarding this and other matters, I can be contacted at manasa@mntaxsolutionsllc.com.