The net investment income (NII) is income received from investment assets such as bonds, equities, mutual funds, loans, and other investments. Net investment income also consists of capital gains, dividends, or interest that will affect the individual tax rate.

It may also include interest from loans you may have made to others and rental property income, capital gain dividends from mutual funds, and even royalties or annuity income.

A realized gain or loss resulting from the transaction proceeds when investors sell assets from their portfolios. The realized profits may include capital gains from the sale of shares, interest income from fixed income investments, dividends paid to company shareholders, rental income from real estate, certain annuity payments, royalties, etc. The net investment income is the difference between realized gains (before taxes) and trade commissions or fees (NII). Whether to sell the asset for a capital gain or loss, NII could be either positive or negative.

What is Net Investment Income (NII) Tax, and how does it work?

The 2010 Health Care and Education Reconciliation Act included the net investment income tax as one of its provisions.

The net investment income tax is a revenue-raising measure that was included to cover the higher expenses of the Affordable Care Act (ACA).

When a taxpayer sells almost any investment, they will either experience a gain or a loss—if they sell for less than they invested in the item, they will lose money. There are certain exceptions, though.

Net investment income excludes tax-exempt state interest. When a gain is excluded from income for income tax purposes, NII spares the profits from the sale of a primary residence. NII also excludes gains on assets owned for use in a trade or business.

Net investment income excludes wages, self-employment earnings, unemployment benefits, Social Security payments, and alimony.

Who pays the Net Investment Income (NII) Tax?

Individuals having Net Investment Income (NII) and Modified Adjusted Gross Income (MAGI) are subject to a 3.8% tax having the above threshold in the following table.

The lower net investment income or the amount of MAGI that exceeds the set threshold is subject to the net investment income tax. A single tax filer, for instance, with an annual gross income of $188,000 and net investment income of $21,055 would have a MAGI of $188,000 + $21,055 = $209,055. The amount is over the limit by $209,055 - $200,000 = $9,055.

Thus, the person will pay a 3.8% net investment income tax on that amount, which comes to $344.09 in total. Capital gains and dividend tax, which the investor still owes, are not included in the NII tax.

Suppose an estate or trust has undistributed net investment income and its yearly adjusted gross income above the threshold at which the highest tax bracket kicks in. In that case, it is also liable for the NII tax. Nonresident aliens are not liable to the tax unless they are married to a citizen or resident of the United States and choose to be classified as a resident for tax purposes.

This income remains for investment businesses after running costs have been deducted from the total investment income. It is commonly expressed on a per-share basis. Divide the total investment income by the number of outstanding shares to get the net income per corporation share. This sum represents the dividends payable to stockholders. A publicly listed company must disclose its net investment income on the balance sheet.

How to calculate Net Investment Income (NII) Tax?

In addition to conventional income taxes, there is a 3.8% surtax, the net investment income tax for 2022. However, not all investors that generate income are affected, and it only applies to incomes above the criteria mentioned above.

To calculate your NIIT, you must also know your modified adjusted gross income (MAGI) and net investment income. Here is the formula for both.

How to calculate Net Investment Income (NII)?

You can determine your net investment income by adding up all of the profits you made from investments during the previous tax year and deducting any associated costs.

This includes, among other types of investment income defined by the IRS, gains you realized when you sold investments, dividend and interest payments you received, and income from rental properties. Fees for tax preparation and commissions may be related costs.

Modified Adjusted Gross Income Calculation (MAGI)

MAGI is a household's adjusted gross income that includes tax-exempt interest payments and certain deductions, such as interest on student loans and contributions to individual retirement accounts (IRAs).

You can find your MAGI on line 11 of the 2020 Form 1040. Then you must add back deductions, including those for student loan interest, tuition costs, IRA contributions, taxable Social Security payments, the deduction for self-employment taxes, and rental losses.

Net Investment Income Tax Calculation

Now that we have the parts let's figure out NIIT. You'll probably be subject to the net investment income tax and need to figure it out on Form 8960 if your MAGI exceeds the abovementioned limits.

It is not enough to multiply your net investment earnings by 3.8% to determine NIIT. You get a pass from the IRS. If your MAGI exceeds the income criteria, you must meet to avoid paying NIITs, and you will be charged 3.8% of the lesser of your net investment income or that amount.

How to avoid Net Investment Income Tax?

You can avoid your tax obligations even if you generate a sizable income from investments by taking actions that lower your reported MAGI, your net investment income, or both.

Making the most of your contributions to IRAs, eligible retirement plans, and deferred compensation plans are some ways to lower your MAGI. You might avoid paying any NII tax if you can reduce your modified adjusted gross income to stay below the cap, as mentioned earlier.

Through tax-loss harvesting, you can also lower your net investment income. You can avoid or reduce your net investment income and hence reduce your tax liability by selling losing investments simultaneously as positive ones. NII can also be decreased by making philanthropic donations, such as

Of course, these are just a few tactics to reduce or avoid the net investment income tax. You should consult with tax professionals when managing tax liabilities for high-income taxpayers and sizable investment holdings.