What Is the Net Investment Income Tax? And Why You Need to Care

Alaska has no income tax. But don’t think you’ll escape the long arm of the Federal tax man.

If you have $40k in Social Security and $20k in IRA distributions you’ll pay nothing to the Feds.

But switch that around to $20k Social Security and $40k IRA and you’re taxes jump to $2871.

Plan wisely before you begin to take Social Security!

When President Obama signed the “Affordable Care Act”, aka Obamacare, it came with a pretty significant tax bite called the Net Investment Income Tax (NIIT).

From the IRS:
“The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.”

Now, you may be thinking, “I don’t have anywhere near $250,000 in MAGI to worry about this tax. So, what’s the big deal?”

But the IRS also states: “Taxpayers should be aware that these threshold amounts are not indexed for inflation”?

Not indexed for inflation… Hmmmm..where have we heard that before? Oh yeah, the provisional income rules for the taxation of Social Security benefits as well as the Alternative Minimum Tax.

When the legislation to tax Social Security and then the Alternative Minimum Tax were first enacted very few people were affected, thus no outrage, as only “the rich” paid. Now almost everyone pays some tax on their Social Security benefits. (As of the 2017 tax bill fewer taxpayers are caught in the AMT web, thankfully.)

Pretty sneaky, eh? Oh, but it gets worse. How is Net Investment Income derived? Again, straight from the IRS website:

What are some common types of income that are not Net Investment Income?
Wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends (see Rev. Rul. 90-56, 1990-2 CB 102) and distributions from certain Qualified Plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b)). (emphasis mine)

Here the IRS is telling us that distributions from retirement accounts are NOT subject to the NIIT, which is factually correct.

What they don’t say is that distributions from retirement accounts are counted as income to determine if you need to pay the NIIT on your dividends, interest and capital gains. Some might even call this an error of omission. I certainly do.

Let me give you an example of how this works.

You are single. You have $180k income. You take a $50k IRA distribution. Your total income now is $230k. That $50k IRA distribution is not subject to NIIT. But if you have capital gains, interest and dividend income, those will be subject to the NIIT because that $50k IRA distribution put you above the $200k threshold!

Large distributions from your qualified accounts could add 3.8% to your tax rate on dividends, interest and capital gains. That is nearly a 25% tax increase!

Yeah, I get it. This tax won’t affect many people so it’s not a huge deal. Well, it’s not a big deal now but I assure you it will be because of inflation, just like taxes on Social Security.

So, what do you do to avoid this??? Take a guess…
Distributions from the Roth are not counted in your Adjusted Gross Income and thus will not ensnare you in NIIT trap.
Once again, YAY for the ROTH! Is there anything it can’t do?

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