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

These Taxes Can, and Should, Be Avoided

One of the drawbacks to a decade-long up market is that there are large amounts of unrealized gains.
Mutual funds with these gains will distribute some, hopefully not all, to shareholders in December. Those shareholders will then be held accountable for the taxes due on said gains…yes, even if those shareholders didn’t actually sell the funds to begin with.

It’s a wonderful aspect of the tax code in relation to how mutual funds work and is just another reason why ETFs are so much more beneficial.  But we’ll save that conversation for a different day.

So, let’s say you have $100k in American Funds Growth Fund of America.  Towards the middle of December you will receive a distribution of around $10k, just from capital gains.  No big deal…except when you go file your taxes next year, you’ll have to pay tax on that $10k.  Depending on your tax bracket you’ll pay 0, $1,500 or even as much as $2.300.  Nice job!

“But”, you say to your tax guy, or Turbo Tax, “I didn’t sell anything.  Why do I have taxes due???”
Your tax guy will simply say, “take it up with Congress.”  And then you’ll stroke that check to the IRS.

Unfortunately, depending on your lot in life, this capital gain distribution may cost you even MORE in taxes because of potential taxation on Social Security benefits, Medicare premiums, and even take a 0 taxed asset and make it 15%.  Wonderful, right???

Oh, so just in case you think it’s only active-managed investment firms that will send you capital gain distributions to pay tax on, here is the video I did on the Vanguard year end distributions.  Not favorable there either.  Fidelity? Think again.  Any fund company that has large capital gains will send you a taxable distribution.

Over the next few emails, I’ll share with you some strategies on how to minimize if not outright avoid these taxable distributions.

But for now, just watch what your fund company says regarding year end capital gain distributions.  It’s not going to be fun when the taxes come due.

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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