The Affordable Care Act, sometimes called Obamacare, is designed to provide healthcare to everyone in America, but that benefit comes with an additional cost – particularly to higher income taxpayers.
That cost is in the form of a new income tax called Net Investment Income Tax (NIIT), also known as the Medicare Contribution Tax. Not only does it lower net investment income, but it also injects a new layer of complexity into the nation’s already overburdened tax system.
With the addition of NIIT, the U.S. tax system now has three layers. One layer is the federal Regular Tax System, the second is the Alternative Minimum Tax System, and the third is NIIT.
Now in place for two years, NIIT must be considered when making income tax planning decisions before the end of each year.
What Is NIIT?
NIIT is applied at the rate of 3.8% of net investment income. Net investment income is calculated by subtracting investment-type, itemized deductions, subject to all of the usual limitations imposed by the federal Regular Tax System, from gross investment income. Gross investment income includes interest, dividends, annuity income, royalties, rents and capital gains.
The good news is that NIIT only applies if a taxpayer’s Modified Adjusted Gross Income (MAGI) exceeds a certain threshold. MAGI is based on regular adjusted gross income, increased by the foreign-earned income exclusion. For individual taxpayers who have not excluded any foreign earned income, their MAGI is generally the same as their regular AGI.
NIIT will not apply if MAGI is below the following thresholds:
- Single taxpayers - $200,000
- Married filing joint taxpayers - $250,000
- Married filing separate taxpayers - $125,000
- Trust taxpayers - $12,000
Careful Tax Planning Is Even More Important Now
In the NIIT era, careful tax planning is absolutely crucial. Working together, clients and their Certified Public Accountants can reduce or even eliminate NIIT. Among the steps that should be considered:
- Maximize contributions to retirement plans. These contributions provide a current tax deferral. When funds are distributed, they are not subject to the 3.8% NIIT.
- Invest in municipal bonds to the fullest extent possible, while staying within your asset allocation strategy. Muni bonds avoid all three types of income tax.
- Re-examine all of your passive investment activities, as well as how they are categorized. Passive income is subject to NIIT. By re-classifying an activity from passive income to active income, active income will still be subject to self-employment tax at the same rate of 3.8%, but there is also a deduction of 1.45%.
- Replace Limit Liability Companies with S-corporations. S-corporations are not subject to NIIT and will pay a lower rate of Medicare tax. Now that we’re living with NIIT, S Corporations may be the best structure for a business entity.
- Consider creating a trust to avoid NIIT. Distributions made from a trust to beneficiaries could avoid NIIT. The NIIT threshold for a trust is only $12,000. It’s important to balance the need to preserve assets versus distributing income to children.
- Think seriously about a Charitable Remainder Trust (CRT). Investment income earned by a CRT is exempt from tax and therefore not subject to the 3.8% NIIT tax.
The Bottom Line
Many lawmakers talk about simplifying our federal income tax system, but NIIT takes that idea in the opposite direction. NIIT adds another layer of complexity to an income tax system that is already overly complicated. When I taught tax courses at Golden Gate University, I would often see my students confounded by a two-layer tax system. Now with this latest metamorphosis of an additional third-layer to our tax system, I can only imagine a much greater level of confusion.
The bottom line is our income tax system has gotten much more cumbersome. For taxpayers and investors, it is vital that all three types of income taxes are considered for year-end tax planning. This will ensure you are paying a fair amount of tax and don’t get tripped up by the complexity in the system.