For tax years after December 31, 2012, individuals, trusts, and estates are subject to a 3.8 percent Net Investment Income Tax (NIIT), if their modified adjusted gross income (MAGI) exceeds a threshold amount determined by their filing status: married filing joint, married filing separately, or single.  Some of you may have experienced this new tax as a part of your 2013 tax return. MAGI is adjusted gross income (AGI) increased by the amount of income excluded under the foreign earned income exclusion. In most cases MAGI and AGI will be the same amount.

The two key amounts to understand regarding the new NIIT are the applicable threshold and what comprises Net Investment Income (NII).

As mentioned, the applicable threshold is determined by filing status.  Your filing status is found on lines 1-5 of Form 1040 as follows:

Line        Filing Status                                     Threshold

1              Single                                               $200,000

2              Married, filing joint                       $250,000

3              Married, filing separately            $125,000

4              Head of household                       $200,000

5              Qualifying widow(er) with          $250,000

Dependent child

After determining the threshold amount that applies, you should refer to line 37 of Form 1040 for your AGI and consider any foreign earned income exclusion that appears in line 21 to determine MAGI.  If MAGI exceeds the threshold amount, you are subject to the NIIT of 3.8 percent.

The amount that is subject to the NIIT is the lesser of your NII or, the excess of your MAGI over the threshold amount.

Next, let’s turn our attention to understanding, generally, what constitutes NII.  There are three categories of income within NII:

  • Category I:
    • Interest income – reported on Form 1040, Schedule B and Form 1040, line 8a
    • Dividend income – reported on Form 1040, Schedule B and Form 1040, line 9a
    • Annuity income – reported on Form 1040, line 16b
    • Royalty income – reported on Form 1040, Schedule E and Form 1040, line 17
    • Rental income –  reported on Form 1040, Schedule E and Form 1040, line 17

These items do not include income derived in the ordinary course of a trade or business.  For instance, if you own a business that operates as a pass-through entity (LLC, partnership, or sub-s corporation as examples) and the entity earns “interest” on trade accounts receivable, this would not be included in your NII.  In fact, the pass-through entity should report this “interest” as “finance charges” and include it as “net income from trade or business activity”.

  • Category II:
    • Gross income from a trade or business in which you do not materially participate; your participation is that of an investor.
  • Category III:
    • Net gains from the disposition of property within an activity that you do not materially participate.

Deductions are allowed against the gross income or net gains in each of the three categories for amounts that are properly allocable to the activity, or earnings of the gross income or realizing the gain.

Two significant income items that are specifically NOT included in NII are distributions from qualified retirement plans or arrangements (including IRAs) and any item taken into account in determining self-employment income that is subject to self-employment tax.

Based upon this information about NII and the NIIT, what types of planning can be done as we approach the end of another year?  It will be important to understand whether your key items of income are considered investment income, passive income, self-employment income, or income from a trade or business, and whether you meet the test for material participation.

It will also be important to understand, generally, what your MAGI is compared to the threshold amount that applies to your filing status.  Are you clearly above the threshold, below the threshold, or very close (either above or below) to the threshold?  If you are very close to the threshold you may make decisions about your investments that will keep you below or take you below the threshold.  For instance, you could ask your financial advisor to harvest some stock portfolio  losses before year end to reduce your MAGI, or you could wait until after year end to harvest stock portfolio gains to keep this year’s MAGI from exceeding the applicable threshold.

Because planning for the NIIT may involve income tax calculations and investment action plans, it would be wise to coordinate your year end planning by arranging a meeting with both your tax professional and your financial advisor.  Having both professionals with you in the same meeting will allow a full compliment of questions to be asked and answered, and you will be able to bring together a year end plan that will be beneficial to your tax and financial health.