Many taxpayers have a basic understanding of federal income tax and that federal income tax rates for individuals range from 10% to 37%. However, there are two lesser well-known taxes that every high-income individual should be aware of — 1) a 3.8% net investment income tax (NIIT), and 2) a 0.9% additional Medicare tax on wage and self-employment income. Below is an overview of these two taxes and what they may mean for you.
3.8% net investment income tax (NIIT)
The NIIT applies, in addition to traditional income tax, to your net investment income. The NIIT only affects taxpayers with adjusted gross income (AGI) exceeding $250,000 for joint filers (MFJ), $200,000 for single taxpayers (S) or heads of household (HOH), and $125,000 for married individuals filing separately (MFS).
If your AGI is above the thresholds described above ($250,000 MFJ; $200,000 S or HOH; $125,000 MFS), the NIIT will apply 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.
What’s considered “net investment income” subject to the NIIT?
This includes interest, dividends, annuities, royalties, rents, and net gains from the sale of property. Passive business income (e.g., income from a partnership Schedule K-1 that you are not an active participant in) is also considered net investment income. NOTE: wage income and income from an “active” trade or business are not considered net investment income.
Income that’s exempt from income tax (e.g., tax-exempt bond interest) would also be exempt from the NIIT. Thus, switching some taxable investments to tax-exempt bonds can reduce your NIIT exposure. Of course, this should be done only if it fits into your overall financial and tax planning strategies. This goes back to the saying, “don’t let the tax tail wag the dog.”
How does the NIIT apply to home sales?
If you sell your principal residence, you may be able to exclude up to $250,000 of gain ($500,000 for joint filers) when figuring your income tax. This excluded gain would not be subject to the NIIT. However, any gain that exceeds the exclusion limit would be subject to the NIIT. Also, gain from the sale of a vacation home or other second residence, which doesn’t qualify for the principal residence exclusion, would also be subject to the NIIT.
Lastly, distributions from qualified retirement plans, such as pension plans and IRAs, are not subject to the NIIT. However, keep in mind that these distributions may push your AGI over the threshold ($250,000 MFJ; $200,000 S or HOH; $125,000 MFS), which could lead to other types of income (e.g. dividends) being subject to the NIIT.
0.9% Additional Medicare tax
Some high-wage earners are subject to an additional 0.9% Medicare tax on part of their wage income, on top of the 1.45% Medicare tax that all wage earners pay. The 0.9% tax applies to wages in excess of $250,000 for joint filers (MFJ), $125,000 for married individuals filing separately (MFS), and $200,000 for all others (S or HOH). It applies only to employees, not to employers.
Once an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0.9% tax. However, this withholding may be insufficient if the employee has additional wage income from a second job or if the employee’s spouse also has wage income. To mitigate this, an employee may request extra income tax withholding by filing a new Form W-4 with the employer.
The additional 0.9% Medicare tax also applies to self-employment income in excess of the same threshold amounts as wage earners. This is on top of the regular 2.9% Medicare tax on all self-employment income. Furthermore, keep in mind that the $250,000 (MFJ), $125,000 (MFS), and $200,000 (S or HOH) thresholds are reduced by the taxpayer’s wage income.
Reduce the impact
As you can see, the NIIT and the 0.9% additional Medicare tax often fly under the radar but could have a significant effect on your tax bill. Please contact your Wegner CPAs tax advisor to discuss these taxes and how their impact could be reduced.
