The Net Investment Income Tax: A Potential Pitfall for the Unwary

A new tax came into effect beginning in 2013, one that you might not have heard of: the Net Investment Income Tax. Basically, any income that is classified as Net Investment Income (NII) is subject to an additional tax at a flat rate of 3.8% of the amount of NII, provided that adjusted gross income (AGI) is above a certain threshold. Come tax season, those to whom the NII Tax applies will need to have paid additional estimated tax on their NII, which may come as a surprise for those who aren’t used to having another tax assessed on certain types of income.

While 3.8% isn’t a large percentage, it can make for a big difference in the estimated tax you will need to pay. You may want to take this new tax into account when making financial decisions — for instance, if you’re trying to decide if you should sell a stock for recognized gain, or if you’re thinking about buying a stock with a higher dividend rate, you should understand that adding any of those types of NII might push you above the threshold to incur this additional tax.

We’ve broken down the essential information about this new tax below.

What is included in NII?

NII includes the types of income normally associated with passive investments, as opposed to earned income, certain benefits, and non-taxable income.  NII includes the following:

  • Interest
  • Dividends
  • Capital gain distributions or dividends from stocks or mutual funds
  • Interest, dividends, and capital gain distributions or dividends of a child reported on Form 8814 for the “Kiddie Tax” (in excess of the threshold amount excluded on Form 8814)
  • Capital gains (such as gains from the sale of stocks, bonds, mutual funds, or annuities, or the gain from the sale of investment real estate, which can include the sale of a second home that is not a primary residence) to the extent not offset by capital losses
  • Rental and royalty income
  • Non-qualified annuities
  • Income from businesses involved in trading financial instruments or commodities
  • Income from passive activities (such as partnerships or other entities that produce passive activity income reported on a Schedule K-1)
  • Gain from the sale of an interest in a partnership or other entity of which you were a passive owner

Investment expenses relating to the investment income can reduce the NII. Some examples of investment expenses include:

  • Investment interest expense
  • Investment advisory and brokerage fees
  • Expenses relating to rental and royalty income
  • State and local income taxes allocable to items included in NII

What is not included in NII?

The following are some common types of income that are not included in NII:

  • Wages
  • Unemployment compensation
  • Social Security benefits
  • Self-employment income (reported on Schedule C of an individual tax return)
  • Operating income from a business that is not treated as a passive activity
  • Alimony
  • Tax-exempt income
  • Income excluded from gross income, such as the exclusion of gain on the sale of a primary residence (currently up to $250,000 of gain, or $500,000 for a married couple)
  • Distributions from certain qualified retirement or profit-sharing plans, or IRAs

What is the threshold for the NII Tax?

The taxpayer is only subject to the NII Tax to the extent that the NII exceeds the applicable threshold amount.  The threshold amount is if the taxpayer’s AGI (modified for certain items of foreign income otherwise excluded under Section 911) is at least the following (depending on how the taxpayer files):

  • For taxpayers filing as married, joint – $250,000
  • For taxpayers filing as married, separate – $125,000
  • For taxpayers filing as single or head of household – $200,000
  • Estates and Trusts – the highest tax bracket amount ($11,950 for 2013)

For example, if taxpayers filing as married, joint have NII of $70,000 and AGI of $190,000, they would not pay any NII Tax because their AGI is below the threshold amount. However, if the AGI was $280,000, then the NII Tax would be 3.8% of $30,000 (the portion of NII in excess of the threshold), or $1,140. The NII Tax is subject to estimated tax provisions, so if the taxpayer expects to be subject to the NII Tax then estimated tax payments should be made.

These threshold amounts are not indexed for inflation.

To whom does the NII Tax apply?

The NII Tax applies to estates, all individuals (except non-resident aliens), and certain trusts. “Grantor trusts” such as revocable or “living” trusts are not directly subject to the NII Tax (although the income of a grantor trust typically would be included in the income of the grantor, so that it would be subject to the tax that way), and certain trusts such as charitable trusts are subject to special rules.

Beware: Some Current Scams Out There

Our practice affords us the opportunity to see various proposals that are sent to our clients, which they often in turn forward to us for review. Here are three scams that we’ve seen quite frequently, which we advise avoiding completely.

Sweepstakes and Lotteries

One of the most vicious schemes, which seems to be targeting residents of retirement communities, are unsolicited sweepstakes and lotteries, which appear to guarantee the targets that they have won hundreds of thousands, if not millions, of dollars. The notices look official, with enclosures that resemble stock certificates guaranteeing eligibility.  One such notice that was forwarded by one our clients is headed “Certificate of Eligibility — Absolute Positive Identification of 100% Eligible Candidate.” The notice is full of reassuring words such as “guaranteed,” “positive,” “verified,” “absolute,” and “official.” Continue reading

Planning in a Down Economy: Does Your Estate Plan Still Make Sense?

Most, if not all of us, are feeling the need to tighten our belts in the current
economic climate. Perhaps you simply are less wealthy as you see equity
in your home or the value of your 401(k) and IRA dwindle. Despite the
feeling that our belts are getting tighter, the tight economic climate is the
appropriate time to review and be sure your estate plan still makes sense.
Just because the economy is still recovering, that does not mean you get
away with putting your long-term estate planning on the shelf. Continue reading