Understanding the Net Investment Income Tax
Provided By: Duane J. Silbernagel
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It’s been around since 2013, but many are still struggling to come to grips with the net investment income tax. The 3.8% tax, which is sometimes referred to as the Medicare surtax on net investment income, affected approximately 3.1 million federal income tax returns for 2013 (the only year for which data is available) to the tune of almost $11.7 billion.1 Here’s what you need to know.
What is it?
The net investment income tax is a 3.8% “extra” tax that applies to certain investment income in addition to any other income tax due. Whether you’re subject to the tax depends on two general factors: the amount of your modified adjusted gross income for the year, and how much net investment income you have.
Note: Nonresident aliens are not subject to the net investment income tax.
What income thresholds apply?
Modified adjusted gross income (MAGI) is basically adjusted gross income–the amount that shows up on line 37 of your IRS Form 1040–with certain amounts excluded from income added back in.
The net investment income tax applies only if your modified adjusted gross income exceeds the following thresholds:
What is net investment income?
Investment income generally includes interest, dividends, capital gains, rental and royalty income, income from nonqualified annuities, and income from passive business activities and businesses engaged in the trade of financial instruments or commodities. Investment income does not include wages, unemployment compensation, Social Security benefits, tax-exempt interest, self-employment income, or distributions from most qualified retirement plans and IRAs.
Note: Even though items like wages and retirement plan distributions aren’t included in net investment income, they are obviously a factor in calculating MAGI. So higher levels of non-investment income can still make a difference in whether the net investment income tax applies.
Gain from the sale of a personal residence would generally be included in determining investment income. However, investment income does not include any amount of gain that is excluded from gross income for regular income tax purposes. Qualifying individuals are generally able to exclude the first $250,000—or $500,000 for married couples filing jointly—of gain on the sale of a principal residence; any of the gain that’s excluded for regular income tax purposes would not be included in determining investment income.
To calculate net investment income, you reduce your gross investment income by any
deductible expenses that can be allocated to the income. So, for example, associated investment interest expense, investment and brokerage fees, expenses associated with rental and royalty income, and state and local income taxes can all be factored in.
How is the tax calculated?
You know your modified adjusted gross income. You know your net investment income. To calculate the net investment income tax, first subtract the threshold figure (shown above) for your filing status from your MAGI. Then compare the result with your net investment income. Multiply the lower of the two figures by 3.8%.
For example, assume you and your spouse file a joint federal income tax return and have $270,000 in MAGI and $50,000 in net investment income. Your MAGI is $20,000 over the $250,000 threshold for married couples filing jointly. You would owe $760 (3.8% multiplied by $20,000), because the tax is based on the lesser of net investment income or MAGI exceeding the threshold.
How is it reported?
If you’re subject to the net investment income tax, you must complete IRS Form 8960, Net Investment Income Tax–Individuals, Estates, and Trusts, and attach it to your federal income tax return (you must file IRS Form 1040). The instructions for IRS Form 8960 provide an overview of the rules that apply and can be a good source of additional information. If you think you may be affected by the net investment income tax, though, it’s a good idea to consider discussing your individual situation with a tax professional.
1 IRS Statistics of Income Bulletin, Spring 2015
Note: The 3.8% net investment income tax, sometimes to as the Medicare surtax on net investment income, originated in revenue provisions included in the Affordable Care Act of 2010. Unlike payroll tax revenues, funds collected from this surtax are deposited into the general fund of the U.S. Treasury; they are not applied to the Medicare Trust Fund.
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This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Waddell & Reed does not provide legal or tax advice. This information is prepared by an independent third party, Broadridge Investor Communication Solutions, Inc. and is provided for informational and educational purposes only. Waddell & Reed believes the information has been obtained from sources considered to be reliable, but does not guarantee the accuracy of the information provided. This information is not meant to be a complete summary or statement of all available data necessary for making financial or investment decisions and does not constitute a recommendation. Please consult with a tax professional regarding your personal situation prior to making any financial related decisions. Also note that the information provided may include references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to you to assist in understanding the issues discussed. Neither Waddell & Reed, Inc., nor its Financial Advisors give tax, legal, or accounting advice. Nothing contained herein is intended as a solicitation or an offer to buy or sell any product or service mentioned and they may not be suitable for all investors.
Duane Silbernagel is a Financial Advisor in Lincoln City, Oregon offering securities through Waddell & Reed, Inc., Member FINRA and SIPC. He can be reached at (541) 614-1322 or via email at DSilbernagel@wradvisors.com.
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