What Is Net Investment Income Tax? | Overview of the 3.8% Tax

What Is Net Investment Income Tax? The 3.8% Tax You May Need to Worry About

If you profit from your investments, this one’s for you. You’re responsible for paying capital gains tax. And depending on how much money you make annually, you may also be responsible for net investment income tax. What is net investment income tax?

What is net investment income tax?

Net investment income tax (also called NII tax, NIIT, or the Medicare Surcharge Tax) is a tax imposed on some higher-earning individuals who profit from investments. Individuals, estates, and trusts with income above the IRS threshold are responsible for paying NII tax on capital gains. 

NIIT is a 3.8% tax imposed on qualifying high-earning individuals who profit from investments (e.g., stocks)

NIIT went into effect at the same time as the additional Medicare tax, which was January 1, 2013. Like the additional Medicare tax, NIIT is a surtax that some individuals are responsible for. 

Before we get into who pays NIIT and how much it is, let’s take a step back. 

Whether you’re a business owner or individual taxpayer, you pay taxes on everything (including tax on investment income). But, the type of tax you pay depends on how you earn the money. So, this tax only comes into play in specific situations. 

If you make money selling investments, you have a capital gain. And, you owe capital gains tax on said capital gain (aka the difference between the price you sell the investment for and what you bought it for). Some individuals who owe capital gains tax also owe NII tax.

Confused? Have questions? We’ve got answers. Read on to learn:

  1. The difference between capital gains tax and NIIT 
  2. What kind of income you have to pay the tax on
  3. Who pays the tax
  4. How much NII tax is (hint: we gave it away in the title)
  5. How to report and pay the tax to the IRS 

1. Net investment income tax vs. capital gains tax: What’s the difference?

Both capital gains tax and net investment income tax apply to investment profits. So, what’s the difference? 

Capital gains tax applies to all qualifying investment profits. Net investment income tax is an additional tax that applies to high-earning individuals who owe capital gains tax. 

Individuals who pay net investment income tax also pay capital gains tax. But, not all individuals who pay capital gains tax owe NII tax. 

Think of it this way: workers pay Medicare tax on their wages. And, some high-earning workers pay additional Medicare tax on their wages above a certain threshold. Capital gains and net investment income taxes work in a similar way. 

2. What kind of income do you have to pay the tax on?

Not all individuals and businesses have to pay net investment income tax, even if they earn above the IRS threshold. Why? Because not everyone A) invests and B) profits from investments. 

So, what kind of situation requires you to pay taxes on investment profits? You may have to pay net investment income tax when you profit from:

  • The sale of stocks, bonds, and mutual funds
  • Distributions from mutual funds
  • Sale of investment real estate 
  • Sale of interests in partnerships and S corporations

Doesn’t sound like anything you’re involved in? You might be free and clear from net investment income tax. NIIT does not apply to:

  • Wages
  • Self-employment income
  • Unemployment compensation
  • Operating income from a business you actively participate in
  • Tax-exempt interest

3. Who pays net investment income tax? 

NII tax applies to high-earning individuals whose modified adjusted gross income (MAGI) is above the IRS threshold, which is:

  • Single: $200,000
  • Married filing jointly: $250,000
  • Married filing separately: $125,000
  • Head of household with qualifying person: $200,000
  • Qualifying widow(er) with dependent child: $250,000

Look familiar? These are the same thresholds the IRS uses for assessing the additional Medicare tax rate of 0.9%. 

You can use the MAGI Worksheet on the IRS’s Instructions for Form 8960 to calculate your modified adjusted gross income. 

If you earn above your filing status’ threshold, you are responsible for paying NIIT on any capital gains you earn. 

4. How much is NII tax?

Unlike federal income tax, there’s a fixed net investment income tax rate of 3.8%.

Calculating your net investment income tax liability should be easy, right? It’s just 3.8%, which means you take your earnings and multiply them by 0.038. However, what you apply the 3.8% to depends…

The 3.8% NIIT applies to the lesser of:

  • Your net investment income (aka the difference between the sale price and purchase price)
  • The portion of your modified adjusted gross income that goes over the threshold 

Example

Let’s say you have $5,000 in net investment income. You file as Single, which has a threshold of $200,000. Your modified adjusted gross income is $210,000, which is $10,000 above the threshold. 

So, do you pay the 3.8% tax on your $5,000 net investment income or on the $10,000 your MAGI exceeds the threshold by?

Because you must pay on the lesser amount, you owe the 3.8% NIIT on the $5,000 in net investment income. Here’s how that would look:

$5,000 X 0.038 = $190

You would owe $190 in NIIT.

5. How do you report and pay the tax?

Calculate and report your NIIT liability on Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts. Attach the net investment income tax form to your tax return.  

Keep in mind that you may have to make quarterly estimated tax payments rather than one lump NIIT payment with your tax return. Include NIIT when figuring your estimated tax liability, if applicable. 

If you have employees who expect to owe NII tax, they can request that you withhold additional income tax from their wages on Form W-4. Although this additional income tax withholding won’t go directly toward their NIIT liability, it can help them pay more in taxes throughout the year. 

The bottom line: Will you owe net investment income tax?

Here’s a cheat sheet you can use to determine if you’ll owe net investment income tax. If you answer “YES” to every question, you are responsible for NII tax:

  • Do you invest in things like stocks, bonds, and mutual funds? 
  • Do you earn gains on the sale of applicable investments or receive capital gain distributions from mutual funds? 
  • Is your modified adjusted gross income above the IRS thresholds?
    • $200,000 (Single or Head of household with qualifying person)
    • $250,000 (Married filing jointly or Qualifying widow(er) with dependent child)
    • $125,000 (Married filing separately)

Remember, NIIT only applies to the amount of profit you earn on an investment. You don’t pay NIIT on other types of income, like self-employment income. 

Whenever you spend or receive money in your business, be sure to record it. And if you’re looking for a better way to track and manage your money, that’s where we come in. Patriot’s online accounting software makes it easy to track expenses and income, automatically import bank transactions, and more. Take advantage of our free trial today! 

This is not intended as legal advice; for more information, please click here.

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