In addition to the standard income tax obligation, high-income taxpayers as well as certain estates and trusts may be subject to the net investment income tax (NIIT), a 3.8% surtax on a portion of modified adjusted gross income (MAGI) over certain threshold amounts. Here, we provide a general overview of the NIIT. As a reminder, please consult your tax advisor or Glenmede Relationship Manager if you have any questions.

What is/is not included in net investment income?¹

Net investment income includes income from investment assets (before taxes) such as stocks, bonds and mutual funds, reduced by the allowable deductions to such income, as well as:

• Taxable interest
• Royalties, rental income (if passive) and income from other passive activities, including partnerships
• Income from the trade or business of trading in financial instruments or commodities
• Capital gains (short- and long-term)
• Dividends (qualified and nonqualified)
• Taxable portion of nonqualified annuity payments

Net investment income does not include, among others:

• Tax-exempt interest from municipal bonds or funds, veterans’ or Social Security benefits, income from qualified retirement plans and IRAs or the excluded gain from the sale of a principal residence
• Income derived from an actively managed trade or business conducted by a sole proprietor, partnership or S corporation
• Wages or unemployment compensation
• Qualified retirement plan withdrawals (e.g., 401(k) or IRA) or payouts from traditional defined benefit pension plans or retirement plan annuities

 Who is subject to the NIIT?

The NIIT applies primarily to high-income individuals and families as well as certain estates and trusts. Individuals are taxed on the lesser of net investment income or the excess of MAGI over the threshold amounts.² The threshold amounts are not indexed for inflation.

What is MAGI, and how does it apply to NII?

For purposes of the NIIT, MAGI is adjusted gross income plus foreign earned income exclusion. For taxpayers with no foreign income, MAGI for net investment income purposes is usually the same as adjusted gross income. There is also an adjustment for passive foreign investment company income or controlled foreign corporation income. This typically pertains to private equity investors, and adjustments are usually nominal.

 Are estates and trusts subject to the NIIT?

Estates and trusts are subject to the NIIT if they have undistributed net investment income and adjusted gross income over the dollar amount at which the highest tax bracket begins.³ Generally, the threshold amount for the upcoming year is updated by IRS each fall (for 2023, it’s $14,450). According to the IRS, grantor trusts and trusts that are exempt from income taxes, such as charitable remainder trusts, are also exempt from the NIIT.

Does net investment income include IRA distributions?

The IRS does not tax IRA or other retirement plan distributions as net investment income. Social Security benefits, tax-exempt interest from municipal bonds, pension plan payouts or retirement plan annuities, and life insurance proceedings are also not defined as part of net investment income by the IRS. For purposes of the NIIT, MAGI is a different calculation from the calculation of MAGI for IRA contributions.

Hypothetical Examples

1. Key takeaway: Only individuals with MAGI above the applicable threshold amount will be subject to the tax. In 2022, Mr. Smith reports:

• $50,000 taxable IRA distribution
• $100,000 of net capital gains
• $25,000 of interest and dividends
• $40,000 of tax-exempt municipal bond income

His MAGI is $175,000. His net investment income is $125,000. The tax-exempt interest does not count toward MAGI or net investment income. Therefore, he is not liable for the NIIT because his MAGI does not exceed the $200,000 threshold.

2. Key takeaway: An individual will pay the 3.8% tax on the lesser of net investment income or MAGI, less the threshold amount. In 2022, Ms. Jones reports:

• $100,000 taxable IRA distribution
• $200,000 of net capital gains
• $25,000 of interest and dividends
• $40,000 of tax-exempt municipal bond income

Her MAGI is $325,000 and net investment income is $225,000. The tax-exempt interest does not count toward MAGI or net investment income. She is liable for the NIIT because her MAGI exceeds the $200,000 threshold. Ms. Jones will pay the 3.8% tax on $125,000 (lesser of the net investment income or MAGI exceeding the threshold).

1 Source: IRS.gov.

2 Source: IRS.gov.

3 IRS.gov.