Net Investment Income Tax - When does it apply, calculating the impact, and how to avoid
The Net Investment Income Tax is an extra tax that is charged on dividends, interest, and capital gains from your investments. It can also apply to many other forms of income, such as rental income, passive business income, and even certain annuity payments.
The tax applies only to individuals and trusts with a MAGI, or Modified Adjusted Gross income, over a certain threshold.
If your income is high enough to cause you to be subject to the tax, you will face an extra 3.8% tax on your investment income or a 3.8% tax on the amount that your annual income exceeds those thresholds.
For someone who relies on dividends and interest to fund their retirement, or those who use their investments for large purchases such as a house or car in retirement, this tax can easily amount to many thousands of dollars.
So, What can you do to avoid this tax?
A little bit of planning can go a long way. If you can split large investment sales over two tax years, you could dramatically reduce the amount of income or capital gains subject to the tax.
Proper investment account maintenance can also help prevent the net investment income tax as well. Things like tax loss harvesting, or purposely recognizing small gains to raise your cost basis over time can help reduce the impact of this tax later on.
Lastly, if you are retired and find yourself frequently hit by the net investment income tax, consider QCDs or Roth Conversions to reduce future required withdrawals and income.