Net Investment Income Tax (3.8% Medicare Surtax)

Since January 1, 2013, a 3.8% Medicare tax, known formally as the Net Investment Income Tax (NIIT) (aka Medicare surtax) applies to certain investment income of individuals, estates, and trusts that exceed statutory threshold amounts. An additional Medicare tax of 0.9% also applies to earned income subject to employment taxes, discussed in Additional Medicare Tax. In the case of individuals, both wages and other forms of compensation for work are added to investment income to determine whether the threshold has been reached and the tax is only assessed on that portion of investment income that exceeds the threshold.^{IRC §1411}

Traditionally, the Medicare tax had been classified as an employment tax, because it was assessed only on employment income. This is the 1^st tax to apply to what had traditionally been considered an employment tax to another form of income. This trend will likely continue, since the government always needs more money, and there was never any strong reason why employment taxes had to apply only to employment income. Indeed, as a flat tax for which there are few deductions and to which few tax credits can be applied, employment taxes are the most burdensome tax to the poor.

Note that the NIIT cannot be offset by the foreign tax credit. The Tax Court reasoned that the NIIT provision is not part of the regular or alternative minimum tax liability for which credits may reduce tax liability.

Who Is Subject to the NIIT?

The tax applies to most types of investment income earned by individuals who earn more than the threshold amounts, even those who are exempt from Medicare taxes.

Nonresident aliens (NRAs) are not subject to the tax but if they are married to a United States citizen or resident and make an election under IRC §6013(g) so that the couple can file jointly, then special rules apply.

Estates and trusts are taxed on undistributed net investment income + adjusted gross income over the highest tax bracket for an estate or trust for that tax year. For instance, for 2022, the threshold amount was $13,450. Certain types of trusts such as charitable remainder trusts and electing small business trusts can use special rules in computing the tax. However, the following types of trusts are not subject to the NIIT:

• trusts exempt from income taxes, such as charitable trusts and qualified retirement plan trusts;
• grantor trusts, since their taxable income is included in the grantor's tax return;
• a trust for which all unexpired interests are devoted to charitable, religious, scientific, literary, or educational purposes, or some other purpose delineated in IRC §170(c)(2)(B);
• trusts not classified as such for federal income tax purposes, such as real estate investment trusts (REITs) and common trust funds.

Net Investment Income

Investment income includes:

• interest and dividends
• nonqualified annuities
• capital gains
  • Gains include that earned from the sale of stocks, bonds, mutual funds, and investment real estate, including a 2^nd home that was not a primary residence, and capital gain distributions from mutual funds. Net investment income also includes gains from the sale of interests in partnerships and S corporations, if the taxpayer was a passive owner.
• rental and royalty income
• businesses that are passive activities for the investor
• income from businesses trading financial instruments or commodities.

Not included:

• wages and unemployment compensation,
• self-employment income,
• operating income from active businesses,
• income from businesses, including partnerships and S corporations, in which the taxpayer materially participates,
• capital gains from the sale of an active business,
• tax-exempt interest,
• alimony,
• Social Security benefits,
• Alaska Permanent Fund Dividends,
• distributions from qualified retirement plans and IRAs.

Note that although distributions from retirement accounts are not included as investment income, distributions from tax-deferred retirement accounts do increase MAGI, so they count in determining whether the income thresholds are exceeded, in which case, the distributions may trigger or increase the NIIT. However, distributions from tax-free Roth retirement accounts, either a Roth IRA or a Roth 401(k), do not count. So, you should consider this when planning your withdrawals from your retirement accounts to minimize taxes!

On the sale of a primary residence, the NIIT only applies to gains exceeding the home sale exclusion amount under IRC §121, which exempts $250,000 ($500,000 for joint filers) of gains from taxation.

Calculating the Net Investment Income Tax

The NIIT is applied to the lesser of net investment income or modified adjusted gross income minus the income threshold. Modified adjusted gross income (MAGI) under NIIT includes any foreign income excluded under the foreign income exclusion rule, less any deductions disallowed under the rule. Thus, taxpayers with foreign investments may have to include that income when calculating the NIIT.

A taxpayer with children who earned income from interest, dividends, and capital gains reported on Form 8814, Parents' Election to Report Child's Interest and Dividends must include those amounts when calculating net investment income. Income that does not have to be included are amounts excluded from Form 1040 because of threshold amounts on Form 8814 and Alaska Permanent Fund Dividends.

Expenses allocable to the earning of the gross investment income are deductible, such as investment interest expense, investment advisory and program fees, expenses incurred to generate rental and royalty income, and state and local taxes assessed on income-producing activities.

Enacted in 2013, an Additional Medicare Tax of 0.9% applies to wages, compensation, and self-employment over applicable thresholds but it does not apply to income includable as net investment income.

When calculating estimated taxes, NIIT must be included in calculating what amounts must be paid to avoid underpayment penalties. However, the tax does not have to be withheld from wages, since an employer has no way of knowing what the employees earn from their investments.

The NIIT is calculated on Form 8960, Net Investment Income Tax − Individuals, Estates, and Trusts and reported on applicable tax returns: Schedule 4 (Form 1040), Form 1040, US Individual Income Tax Return and Form 1041, US Income Tax Return for Estates and Trusts.