Net investment income (NII), for tax purposes, is the total amount of money received from assets such as stocks, bonds, and mutual funds, minus related expenses.
NII may include interest income, dividend income, and capital gains. Whether this income, minus the expenses, is taxable is determined by the taxpayer’s modified adjusted gross income (MAGI).
Key Takeaways
- Net investment income includes earnings from assets like stocks, bonds, mutual funds, and more, less any related expenses.
- NII is subject to a 3.8% tax for individuals and entities with an NII and MAGI above specific thresholds.
- Estates and trusts face the NII tax if they have undistributed NII and surpass certain income levels.
- For investment companies, NII is what’s left after operating expenses are subtracted from total investment income.
- The net investment income tax began in 2013 to fund the Affordable Care Act.
Unraveling Net Investment Income (NII)
Income encompasses any money or compensation earned by individuals or businesses—whether through labor, products, services, or investments. When investors sell assets, the proceeds result in either a realized gain or loss. Realized gains can include:
- Capital gains from the sale of stock
- Interest income from fixed-income products
- Dividends from company shares
- Rental income from properties
- Certain annuity payments
- Royalty payments
Expenses like trading commissions are deducted from realized gains to arrive at net investment income, which does not include wages.
NII has been taxable above certain thresholds since Jan. 1, 2013, following the Health Care and Education Reconciliation Act of 2010. The tax aims to offset Affordable Care Act costs with a rate of 3.8% on “certain net investment income of individuals, estates, and trusts surpassing statutory thresholds.”
NII may be positive or negative depending on the capital gains or losses of the assets sold.
Defining What Counts as NII
Below is a table showing what counts and what doesn’t count as net investment income.
| Net Investment Income: What Counts and What Doesn’t | |
|---|---|
| What Counts | What Doesn’t Count |
| - Interest income | - Wages and salaries |
| - Capital gains | - Alimony |
| - Dividends | - Social Security benefits |
| - Passive investment income | - Unemployment benefits |
| - Rental income | - Qualified distributions from 401(k)s or IRAs |
| - Royalty income | - Life insurance payouts |
| - Non-qualified annuity distributions | - Income from active business investments |
| - Business income (financial trading activities) | - Proceeds from tax-exempt organizations and transactions |
Who Pays the NII Tax?
Net investment income is subject to a 3.8% tax if income limits are exceeded. The tax impacts:
Individuals
The tax applies to those with NII within a specific modified adjusted gross income (MAGI) threshold. Thresholds below are not indexed for inflation.
| Threshold for Net Investment Income Tax | |
|---|---|
| Filing status | MAGI Limit ($) |
| Single | $200,000 |
| Head of Household | $200,000 |
| Married filing separately | $125,000 |
| Married filing jointly | $250,000 |
| Qualified widow(er) with dependent | $250,000 |
The tax is applied to the lesser of net investment income or the excess MAGI amount.
Estates and Trusts
Estates and trusts pay the NII tax if they have undistributed NII and their adjusted gross income (AGI) surpasses the highest tax bracket’s starting amount, $14,450 in 2023 and $15,200 in 2024.
A nonresident alien isn’t subject to the tax unless married to a U.S. citizen or resident and opts for U.S. tax purposes.
Investment Companies
For investment companies, NII is the income left after subtracting operating expenses from total investment income, typically on a per-share basis. Divide total investment income by shares outstanding to find the net investment income per share.
Calculation of the NII Tax
To calculate NII tax, compute income from all qualified investments and subtract fees like commissions and brokerage charges. Get your MAGI by adding excluded income and certain deductions like student loan payments.
Determine the 3.8% tax on the lesser of your NII or the portion of your MAGI that exceeds filing thresholds using IRS Form 8960 or compute yourself.
Two simple scenarios:
Scenario 1: Exceed MAGI by $30,000, paying 3.8% tax only on $25,000 because it’s less than the excess over the threshold.
Scenario 2: Exceed MAGI by $10,000, paying 3.8% tax only on $10,000 as it’s less than NII.
NII tax is in addition to capital gains or dividends tax.
Effective Management of the NII Tax
Even with significant investment returns, reduce tax liabilities by lowering taxable AGI or NII.
Methods include maximizing IRA contributions, participating in deferred compensation plans, or tax-loss harvesting by selling losses alongside gainers.
Charitable contributions, such as to a charitable remainder trust, can also lower NII.
Paying the NII Tax
Report NII with IRS Form 8960, which is then transferred to the main tax form:
- For individuals, Form 1040.
- Estates and trusts, Form 1041.
Example of NII
Imagine an individual sells 100 shares of Apple for $175/share, 50 shares of Netflix for $170/share, earns $2,650 in bond coupon payments, and $16,600 from rental income. Their NII calculation would be:
| Investment Income | Amount |
|---|---|
| Capital gain from AAPL: (Sale Price $175 - Cost $140) x 100 | $3,500 |
| Capital loss from NFLX: (Sale Price $170 - Cost $200) x 50 | ($1,500) |
| Brokerage commissions | ($35) |
| Interest income | $2,650 |
| Rental income | $16,600 |
| Tax preparation fees | ($160) |
| Net Investment Income | $21,055 |
Qualifying Net Investment Income Breakdown
NII includes interest, capital gains, royalties, rent, dividends, certain annuity payments, and originates from stocks, bonds, properties, mutual funds, and other investments.
Taxpayers with MAGI exceeding certain amounts based on filing statuses may incur the tax.
Entities like estates and trusts also follow similar tax implications.
Calculating Your Net Investment Income Tax
Use IRS Form 8960 to calculate or add up all income and subtract fees before determining MAGI. Pay 3.8% on the lower of NII or the excess portion over your MAGI threshold.
Avoiding the Net Investment Income Tax
To avoid it, maintain MAGI below set thresholds. Strategies for investing can reduce exposure-seek tax professionals’ advice for optimal actions.
The Bottom Line
Investments can prepare you for the future or cover emergencies but might increase your tax bill via NII tax. Net investment income involves earnings minus related expenses, taxed based on exceeding MAGI thresholds or your total NII.
Correction—Nov. 16, 2023: Contribution to qualified retirement plans can reduce AGI and tax liabilities.
Related Terms: Modified Adjusted Gross Income, Capital Gains, Dividend Income, Interest Income.
References
- Internal Revenue Service. “Find Out if Net Investment Income Tax Applies to You”.
- Congressional Research Service. “The 3.8% Net Investment Income Tax: Overview, Data, and Policy Options”, Page 1.
- Internal Revenue Service. “Questions and Answers on the Net Investment Income Tax”.
- Internal Revenue Service. “26 CFR 601.602: Tax Forms and Instructions; Rev. Proc. 2022-38”, Page 8.
- Internal Revenue Service. “26 CFR 601.602: Tax Forms and Instructions; Rev. Proc. 2023-34”, Page 7.
- Cornell Law School, Legal Information Institute. “26 CFR § 1.1411-4 - Definition of Net Investment Income”.
- Internal Revenue Service. “About Form 8960, Net Investment Income Tax Individuals, Estates, and Trusts”.
