Net investment income tax

The Net Investment Income Tax (NIIT), also called the 3.8% tax, is an additional federal tax on investment income for high earners. If your income exceeds $200,000 (single) or $250,000 (married filing jointly), you must pay a 3.8% tax on the lesser of (a) your net investment income or (b) the excess of your total income over the threshold. The tax applies to capital gains, dividends, interest, and passive income, but not wages.

How NIIT is calculated

You have income of $250,000 (single): $180,000 wages + $70,000 investment income.

Threshold for single: $200,000. Excess over threshold: $250,000 - $200,000 = $50,000.

Your net investment income is $70,000. NIIT applies to the lesser of (a) $70,000 or (b) $50,000 = $50,000.

NIIT = $50,000 × 3.8% = $1,900.

What counts as “net investment income”

Includes:

• Long-term and short-term capital gains
• Dividends (qualified and ordinary)
• Interest
• Passive income (rental real estate, passive partnerships)
• Annuity income
• K-1 income from passive activities

Excludes:

• Wages and salary
• Self-employment income (even if you are self-employed investor)
• Social Security
• Tax-exempt interest (municipal bonds)
• Health savings account distributions

Why self-employment income is excluded

An oddity: NIIT does not apply to self-employment income. A software entrepreneur with $1 million in business income is not subject to NIIT, even if wealthy. But an investor with $1 million in capital gains or dividend income is.

This creates a planning incentive: some wealthy individuals structure investments as “business” to avoid NIIT.

Threshold adjustments

The thresholds ($200,000/$250,000) are not indexed for inflation. As inflation rises, more taxpayers cross the threshold, expanding the tax base. Congress set these thresholds in 2010; they have not moved.

Combined effective rate on investment income

For a wealthy investor (37% federal bracket) in a high-tax state (say, 13.3% California), NIIT adds significantly:

• 37% federal marginal rate
• 13.3% California income tax
• 3.8% NIIT
• Total: 54.1% on capital gains

This is one of the highest tax rates in the US on any form of income.

Reported on Form 8960

If you are subject to NIIT, you calculate it on Form 8960 and attach to your 1040. The NIIT is paid with your regular tax return.

If your income is below the threshold, you do not file Form 8960 (it is not required).

Strategy: timing and income sources

High earners sometimes use strategies to avoid NIIT:

1. Harvest losses: Realize capital losses to offset gains, reducing net investment income.
2. Use tax-deferred accounts: Income in IRAs and 401(k)s is not subject to NIIT.
3. Hold for long-term gains: Though NIIT applies to both short- and long-term, long-term gains are taxed at lower regular rates, reducing absolute tax.
4. Defer realization: Do not sell appreciated assets; defer taxation via 1031 exchange or other mechanisms.

Medicare funding connection

NIIT was enacted as part of the Affordable Care Act to help fund Medicare. It is sometimes called the “Medicare surtax” for that reason.

State NIIT

A few states (Vermont, New Jersey, Illinois) have enacted their own versions of NIIT. These apply on top of the federal 3.8%.

Interplay with other taxes

NIIT is calculated after regular income tax. It increases total tax burden but does not trigger alternative minimum tax (NIIT is not an AMT preference).

See also