Are you liable for net investment income tax? Learn strategies to reduce the risk

During the last several years, the 3.8% net investment income tax (NIIT) has ensnared a steadily increasing number of taxpayers. Why? Because when the tax was enacted 11 years ago it applied to “high earners” — defined as single filers with modified adjusted gross income (MAGI) over $200,000 and joint filers with MAGI over $250,000. Those thresholds have never been adjusted for inflation. As a result, the number of taxpayers liable for NIIT has more than doubled during that time.

If you fall into the “high earner” bracket, familiarize yourself with the NIIT. The good news is there may be strategies you can use to reduce, or even eliminate, this tax.

NIIT explained

Net investment income (NII) is gross income (less allowable expenses) from taxable interest, dividends, capital gains, rents, royalties and passive business interests. It does not include wages, income from a business you actively manage (except for trading financial instruments or commodities), tax-exempt interest, taxable distributions from IRAs or qualified retirement plans, and Social Security benefits, among other things.

Also excluded from NII is the tax-exempt portion of your net gain on the sale of a principal residence ($250,000 for single filers; $500,000 for joint filers), but to the extent your gain exceeds the exemption amount, it is subject to NIIT.

If your MAGI (for most people, MAGI is the same as adjusted gross income) exceeds the applicable threshold, the NIIT applies to the lesser of 1) your NII, or 2) the amount by which your MAGI exceeds the threshold. Suppose, for example, that Mary, a single filer, typically earns MAGI of $175,000, consisting of $150,000 in wages and $25,000 in interest and dividends. In 2023, she sells stock at a gain of $75,000, so her MAGI for 2023 is $250,000 ($175,000 + $75,000) and her NII for 2023 is $100,000 ($25,000 + $75,000). The NIIT applies only to the $50,000 in income above the $200,000 MAGI threshold — for an additional tax of $1,900 ($50,000 × 3.8%).

What if Mary’s wages were over $200,000? In that case, the entire $100,000 in NII would be taxable, so she would owe $3,800 in NIIT.

Strategies for reducing NIIT

Tax planning strategies for reducing NIIT generally fall into two categories:

• Strategies that reduce your NII; and
• Strategies that reduce your MAGI.

Depending on your income level, reducing MAGI can lower your NIIT by reducing the amount by which your MAGI exceeds the threshold. For example, suppose Mark and Donna, a married couple filing jointly, have MAGI of $350,000, consisting of $250,000 in wages and $100,000 in NII. If they reduce their NII by $25,000 to $75,000, they will save $950 in NIIT ($25,000 × 3.8%). Reducing their MAGI by $25,000 will have the same effect, even if their NII remains the same, because the excess of their MAGI over the threshold will drop to $75,000.

Potential strategies for reducing NII include:

• Reducing capital gains by harvesting losses — that is, selling stocks or other securities that have declined in value — and offsetting those losses against gains;
• Reducing interest income by shifting investments into tax-exempt municipal bonds;
• Reducing dividends by shifting investments into growth stocks that pay low or no dividends; and
• Transferring income-producing investments to children or other family members in lower tax brackets.

Potential strategies for reducing MAGI include:

Increasing Tax-Deductible Contributions to Traditional IRAs, 401(K) Plans, Health Savings Accounts or Similar Accounts
These are “above-the-line” deductions that reduce gross income. Below-the-line deductions — such as mortgage interest, medical expenses and charitable donations — do not affect gross income and, therefore, cannot reduce NIIT.

Making Qualified Charitable Distributions from a Traditional IRA
If you are over 70½ and charitably inclined, you can donate up to $100,000 per year directly from your IRA to one or more qualified charities. These donations reduce the amount of any required minimum distributions you would otherwise have to take, keeping those funds out of your gross income.

Converting Traditional IRAs into Roth IRAs
(See “Can a Roth IRA conversion reduce NIIT?” below.)

Often, people who are not ordinarily subject to NIIT find themselves liable for the tax because of a significant one-time gain — for example, the sale of a large holding of appreciated securities. In those cases, it may be possible to reduce, or even eliminate, NIIT by spreading the sale over two or more years.

Consider NIIT when making investment decisions

The NIIT is a relatively small tax, but it can have a big impact on your investment decisions. Say you are comparing a taxable bond to a similar tax-exempt municipal bond. To be sure you are comparing apples to apples, ask your tax advisor to calculate the tax-equivalent yield — that is, the return the taxable bond must earn so that it is after-tax yield is equal to the yield on the municipal bond. Whether the taxable bond is subject to the NIIT can be a significant factor.

Sidebar: Can a Roth IRA conversion reduce NIIT?

When you convert a traditional IRA to a Roth IRA, you are immediately subject to tax on the converted amount (to the extent that itis attributable to deductible contributions and earnings on those contributions). So, if you are contemplating such a conversion, you need to compare the current tax cost with the tax savings you will enjoy in the future. Qualified withdrawals from Roth IRAs are tax-free, and Roth IRAs are not subject to the required minimum distribution rules.

As you compare the relative costs and benefits, consider the potential impact of the 3.8% net investment income tax (NIIT). Although distributions from a traditional IRA are not subject to NIIT, they do increase your modified adjusted gross income, which can trigger or increase the NIIT.

This is true for the conversion to a Roth IRA. Distributions from Roth IRAs are excluded from gross income, so they are not subject to NIIT. Whether the Roth conversion ultimately reduces NIIT depends on factors such as whether the conversion increased the NIIT that was due at that time. It also depends on whether — and to what extent — taking a distribution from the Roth IRA allows you to reduce the NIIT that would have been owed if you would taken the same distribution from a traditional IRA.

Considering home improvements? Tax credits can make going green easier

If you are planning improvements that will boost your home’s energy efficiency, be sure to consider tax incentives that may offset some of the cost. The Inflation Reduction Act (IRA), signed into law in 2022, extended and expanded tax credits that reward homeowners who “go green.”

New-and-improved EEHIC

The Energy Efficient Home Improvement Credit (EEHIC) — previously known as the Nonbusiness Energy Property Credit — expired at the end of 2021. However, it was revived, renamed and improved by the IRA. The old credit was subject to a $500 lifetime limit, but now you may qualify for tax credits of up to $3,200 per year.

Starting in 2023, the EEHIC equals 30% of qualified expenses for energy efficiency improvements, residential energy property and home energy audits. The maximum aggregate annual credit for most improvements is $1,200 per year, with the following limits for certain expenditures:

• $150 for home energy audits;
• $150 per door for exterior doors (up to $500 total); and
• $600 for exterior windows and skylights, central air conditioners, electrical panels and related equipment, natural gas, propane and oil water heaters or furnaces, and hot water boilers.

A separate aggregate limit of $2,000 per year applies to electric or natural gas heat pump water heaters, electric or natural gas heat pumps, and biomass stoves and boilers. This means that it is possible to claim credits totaling up to $3,200 per year through 2032, when the EEHIC expires. If feasible, consider spreading your qualifying home improvement projects over the next several years to make the most of these credits.

Rules and restrictions

To qualify for the EEHIC, your home must be in the United States. It also must be an existing home that you improve upon or add to. (The credit is not available for new homes.) In most cases, the home must be your primary residence. Landlords or other property owners who do not live in the home cannot claim the credit.

What if you have a home office or otherwise use the property for business? If you use the property exclusively for business, the credit is unavailable. However, you can claim a partial credit if you use your home partly for business. If the business use is 20% or less, you are entitled to the full credit. If it is more than 20%, the credit is based on the portion of your expenses allocable to nonbusiness use.

Beginning in 2025, the EEHIC will not be allowed for any purchase of energy-efficient property unless it is produced by a qualified manufacturer that assigns a qualified product identification number to the item. You must include that number on your tax return when claiming the credit.

Get the credits you deserve

To lower the cost of going green, be sure to take advantage of the tax incentives available to you. In addition to the EEHIC, consider 1) the residential clean energy credit for investments in solar, wind, geothermal and fuel-cell technology, and 2) the alternative fuel refueling property credit for electric vehicle charging stations or property used to store and dispense clean-burning fuel. State tax incentives may also be available.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.