High-income taxpayers face a special tax-a 3.8% net investment income tax. Here's an overview of this tax and what it means to you.
This tax applies, in addition to income tax, on your net investment income. The tax only affects taxpayers whose adjusted gross income (AGI) exceeds $250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately. These threshold amounts aren't indexed for inflation. Thus, as time goes by, inflation will cause more taxpayers to become subject to the 3.8% tax.
Your AGI is the bottom line on Page 1 of your Form 1040. It consists of your gross income minus your adjustments to income, such as the IRA deduction.
If your AGI is above the threshold that applies to you, the 3.8% tax applies to the lesser of (1) your net investment income for the tax year or (2) the excess of your AGI for the tax year over your threshold amount. This tax is in addition to the income tax that applies to that same income.
Take, for example, a married couple that has AGI of $270,000, of which $100,000 is net investment income. They would pay a net investment income tax on only the $20,000 amount by which their AGI exceeds their threshold amount of $250,000. That is because the $20,000 excess is less than their net investment income of $100,000. Thus, the couple's net investment income tax would be $760 ($20,000 × 3.8%).
Now assume that the couple's AGI was $350,000. Because their AGI exceeds their threshold amount by $100,000, they would pay a net investment income tax on their full $100,000 of net investment income. Their tax would then be $3,800 ($100,000 × 3.8%).
What is net investment income? The "net investment income" that is subject to the 3.8% tax consists of interest, dividends, annuities, royalties, rents, and net gains from property sales. Income from an active trade or business isn't included in net investment income, nor is wage income.
However, passive business income is subject to the net investment income tax. Thus, rents from an active trade or business aren't subject to the tax, but rents from a passive activity are subject to it.
Income that is exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the 3.8% net investment income tax. Thus, switching some of your taxable investments into tax-exempt bonds can reduce your exposure to the 3.8% tax. Of course, this should be done with due regard to your income needs and investment considerations.
Home sales. Many people have asked how the 3.8% tax applies to home sales. If you sell your main home, you may be able to exclude up to $250,000 of gain, or up to $500,000 for joint filers, when figuring your income tax. This excluded gain isn't subject to the 3.8% net investment income tax.
However, gain that exceeds the limit on the exclusion is subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn't qualify for the income tax exclusion, is also subject to the net investment income tax.
For example, say that a married couple has AGI of $200,000 and in addition sold their main home for a $540,000 gain. The couple qualified for the full $500,000 exclusion of gain on the sale, leaving only $40,000 of taxable gain. As a result, the couple isn't subject to the 3.8% tax, because their total AGI ($200,000 + $40,000) falls below the $250,000 threshold.
But if the gain on the home sale was $680,000, of which $180,000 was taxable, the couple would be subject to the 3.8% tax on $130,000 of the gain. That is the amount by which their total AGI of $380,000 ($200,000 + $180,000) exceeds their $250,000 threshold.
Retirement plan distributions. Distributions from qualified retirement plans, such as pension plans and IRAs, aren't subject to the net investment income tax. However, those distributions may push your AGI over the threshold that would cause other types of investment income to be subject to the tax.
This makes Roth IRAs more attractive for higher-income individuals, because qualified Roth IRA distributions are neither subject to the net investment income tax nor included in AGI. Distributions from traditional IRAs are included in AGI, except to the extent of after-tax contributions, although they aren't subject to the net investment income tax.
How the tax is reported and paid. The net investment income tax is computed on Form 8960, attached to and filed with your Form 1040. The tax must be paid at that time.
The net investment income tax must be taken into account in calculating your quarterly estimated tax. Thus, if you expect to be subject to the tax, you may have to make or increase your estimated tax payments to avoid an underpayment penalty.
As you can see, this tax has a significant effect on your tax picture. If you would like to discuss this tax and how its impact can be reduced, please contact us.