The net investment income tax, also known as NIIT, is an additional 3.8% federal tax on certain net investment income of individuals, estates and trusts. It was passed as part of the Affordable Care Act in 2010, and applies to taxpayers with modified adjusted gross income over $200,000 ($250,000 for married filing jointly; $125,000 for married filing separately). This tax can take a big bite out of investment returns, so it’s important for higher-income investors to understand legal ways to reduce their exposure. Here are 5 strategies to avoid or reduce net investment income tax legally.
Invest in Tax-Deferred Retirement Accounts to Avoid NIIT
Contributions to tax-deferred retirement accounts like 401(k)s, 403(b)s, and IRAs can help investors avoid net investment income tax. The income on these accounts grows tax-deferred, meaning you don’t pay taxes until you withdraw funds in retirement. This allows you to avoid NIIT exposure on the growth. Maxing out contributions to retirement accounts each year is an effective way to shield a portion of your investment income.
Harvest Tax Losses to Offset Investment Income
Net investment income tax applies to net investment income after subtracting properly allocable deductions. One strategy is tax-loss harvesting – selling investments at a loss to offset capital gains and potentially other investment income. For example, if you realize $5,000 in capital losses, you can use $3,000 to offset ordinary income and carry forward the remaining $2,000 to future years to offset capital gains or investment income subject to NIIT.
Invest in Tax-Exempt Municipal Bonds
Interest income from tax-exempt municipal bonds is not subject to federal income tax or net investment income tax. Focusing your fixed income investments on municipal bonds can help avoid NIIT on the interest income generated. Just be aware of the tradeoffs – municipal bonds tend to offer lower nominal yields compared to taxable bonds.
Structure Investments in Separate Accounts for Your Children
Parents can avoid net investment income tax by gifting investments to children who have lower incomes. You can invest in separate accounts for your children, keeping income below the NIIT thresholds. However, investment gains will generally be taxed at the higher trust tax rates. Proper planning is important to balance tax savings with overall family tax efficiency.
Donate Appreciated Investments to Charity
Donating long-term appreciated securities directly to charity is another way to potentially avoid NIIT. You can deduct the full market value of the donated investments as an itemized charitable deduction to offset net investment income. This results in tax savings compared to selling the investments and donating the proceeds.
The net investment income tax can take a sizable bite out of returns for higher earners. With proper planning, there are legal ways to avoid or reduce exposure through strategies like maximizing retirement contributions, harvesting tax losses, donating to charity, and structuring investments for children. Consult a tax advisor to map out a customized plan.