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The 3.8% Federal Surtax - What To Know

The 3.8% Federal Surtax - What To Know

February 26, 2024

 
A 3.8% Surtax on a filer’s income from sources like interest, dividends, and capital gains applies if adjusted gross income, or AGI, is above $200,000 for most single filers or $250,000 for most married couples. The tax, which is added to the regular income tax, is due on the smaller of NII or the excess of AGI over specific income thresholds.

What is Net Investment Income (NII)?

Net Investment income includes dividends, interest, capital gains, passive rental income, royalties, and passive trade or business income.

NII does not include wages, pensions, social security, retirement plan payouts, or self-employment income. Tax-free municipal bond income is exempt as well.

Example:

Joseph and Linda, married, had $270,000 of Adjusted Gross Income (AGI). Included in their AGI was $230,000 of wages and the following Net Investment Income:   
                                       
Net Rental Income                               14,000
Interest                                                    7,000
Capital Gain                                          11,000
Dividends                                                8,000
Total Net Investment Income            $40,000  

  The Net Investment Income Tax is calculated on the smaller of:

 The Net Investment Income of $40,000, or the excess of AGI over the income threshold of $20,000 ($270K - $250K). The additional surtax will be calculated as follows: $20,000 x 3.8% = $760.00.

 If the couple’s AGI were $350,000, the surtax would be applied to the full $40,000 of net investment income ($1,520 tax) since $40K is smaller than $100K ($350K - $250K).

 

Why are more people subject to NII tax in 2024?

The $200K and $250K thresholds have not changed since 2013. Most threshold limits in other tax categories include adjustments for inflation - but not this one. Had the $200,000/$250,000 thresholds been indexed for inflation, they would be closer to $264,000 and $330,000. In addition, higher interest income for cash investments such as money market funds, CDs, and Savings accounts have pushed more people into the NIIT-paying crowd. 

 

Can income from trade or businesses be subject to NII tax?
Yes. Trade or business income derived from passive activity can also be NII, provided the income is not otherwise subject to self-employment tax. The test for determining a passive activity is Material Participation. This rule applies to income from activities engaged in directly by individuals and to pass-through income from LLCs, limited partnerships, and S corporations.

 

How to Avoid The NIIT?

Since the 3.8% surtax is based on the taxpayer’s adjusted gross income (AGI), ways of lowering AGI should be explored. Below are a few:

Larger contributions to retirement plans.
Tax-deductible contributions to traditional IRAs, 401(k)s, or Health Savings Accounts help reduce AGI, reducing the surtax.

Converting Traditional IRAs to Roth IRAs
Although there is a tax due on the conversion amount (and increased income in the year of the conversion), the potential benefit in the long term is tax-free distributions that evade income tax and any surtax. See Roth IRA Blog.

Muni Bonds
Interest from Muni-Bonds is not included in Adjusted Gross Income and is exempt from Federal and State taxes. Because of the tax-exempt feature, yields are typically lower for Muni Bonds, but the income tax and the NIIT saved could more than compensate for the lower yields.  

Taxable (Brokerage) v. Non-Taxable (Qualified)
Reviewing your asset allocations to ensure optimal placement of different investments can lower AGI if you have both qualified and taxable retirement accounts. For example, investments that pay regular interest income (i.e., bonds, CDs, savings) would provide better tax protection in qualified accounts (IRAs, 401K) since the interest income is tax-deferred in qualified accounts and excluded in AGI until withdrawals are taken.

Harvesting Losses.
Reviewing your brokerage accounts (taxable) at year-end can provide opportunities to realize tax losses that can offset both capital gains and ordinary income ($3K max). Using the example above for James and Linda, their $14K amount of capital gain and an additional allowed $3K could be offset if some of their loss-position investments were sold and the capital losses were realized. The tax savings would have to be greater than the potential upside of disciplined investing (to hold the loss positions). See Tax Harvesting Blog.

Qualified Charitable Deductions
Taxpayers taking Required Distributions from their IRAs can donate up to $100,000 per year to qualified charities and count the donations toward their required payouts, keeping the income out of AGI.


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