As the deadline for filing 2016 tax returns approaches, some taxpayers are still struggling with the rules for the 3.8% tax on “net investment income” (NII). The tax law provision authorizing this special tax was included in the Affordable Care Act (ACA), the law known as Obamacare. Although the ACA may be repealed by the new Trump administration, it would not likely be retroactive to 2016.
Basic premise: The 3.8% tax applies to the lesser of your NII or the amount by which your modified adjusted gross income (MAGI) exceeds an annual threshold of $200,000 for single filers and $250,000 for joint filers. The tax is also imposed on trusts and estates with income above the threshold, based on the dollar amount of the highest tax bracket.
For this purpose, NII includes interest and dividends; distributions from annuities (other than tax-deferred distributions); rent and royalties; gains from investments in passive activities; trades of financial instruments and commodities; and net capital gain from the sale of property (other than property held in an active trade or business). Significantly, it does not include salary or wages; distributions from IRAs and qualified retirement plans; taxable Social Security income; active trade or business income; self-employment income; gain on the sale of active interests in a partnership, S corporation or limited liability company; income from tax-exempt municipal bonds; and tax-deferred income from nonqualified annuities.
In some cases, taxpayers may owe the tax based on NII, in other cases tax based on the excess MAGI and in still others they may not have to pay the tax at all.
Example 1: Alice is a single filer with NII of $25,000 in 2016. When she completes her 2016 return, she determines that her MAGI is $250,000. Because the NII of $25,000 is less than the excess MAGI of $50,000, Alice has to pay a tax of $950 (3.8% of $25,000).
Example 2: Bob is a single filer with NII of $40,000 in 2016. When he completes his 2016 return, he determines that his MAGI is $220,000. Because the excess MAGI of $20,000 is less than the NII of $40,000, Bob has to pay a tax of $760 (3.8% of $20,000).
Example 3: Carol and Ted are joint filers with NII of $100,000 in 2016. When they complete their 2016 return, they determine that their MAGI is $225,000. Because their MAGI does not exceed the threshold, Carol and Ted do not have to pay the 3.8% tax.
If you owe the tax for 2016, there is not much you can do about it now. Going forward, you may consider several strategies for reducing NII and/or MAGI, including postponing large capital gains, selling real estate on an installment basis, investing in tax-free municipal bonds, converting assets in a traditional IRA to a Roth IRA in a low tax year and using a charitable remainder trust, just to name a few.