You better know the truth about Biden's new Net Investment Income Tax

Did you know that Uncle Sam has an extra tax on investment income for high earners? Despite the claims made by President Biden, taxes are rising, and not just on those who are making above $400,000 per year. The net investment income tax, or NIIT, starts to affect taxpayers who have adjusted gross income of just $200,000. I'm going to give you the facts about how it could hit your wallet. Stay tuned.

Welcome to We Are Talking Money. I'm Phil Clark, founder of OmniStar Financial Group, and this episode is all about NIIT, or net investment income tax. Now, before we get started, please do me a favor and hit that thumbs up button if you like this kind of content. And while you're at it, why not subscribe to our channel? You'll be glad that you did, because every week we're putting out new content that's designed for one thing, that is to help you stay informed and make better financial decisions. Okay, let's get into it.

In many ways, yields on bank accounts and bonds have been a real blessing for those on fixed incomes. Of course, the reason for these higher yields is anything but a blessing, and that's because higher yields resulted from runaway inflation, something that makes it pretty tough on everyone. Nevertheless, higher income is a good thing. Well, yes, but some of the good is lost if you owe more tax.

And the United States of America is not shy about its out-of-control spending, and there is no end in sight. In fact, we hear debt ceiling talks literally as we're doing this video. Helping to offset the stratospheric spending is to charge taxpayers with net investment income tax, or NIIT for short. It's just a 3.8% surtax on a filer's income from sources like interest and dividends, capital gains, and it applies if adjusted gross income, or your AGI, is above $200,000 for single filers or $250,000 for most married couples.

It affects one-time spikes as well as recurring income, so taxpayers who typically earn less, they can owe it on a windfall. Although the 3.8% rate is low, the NIIT deserves a close look, because even small taxes can affect investment decisions and ultimately the amount of money that you're putting in your pocket.

And the NIIT reach is expanding. What I mean is, when lawmakers enacted it to help fund things like Obamacare, these lawmakers chose, deliberately I might add, to avoid adjusting this 200,000 or $250,000 threshold for inflation. And what that means is, because those thresholds don't rise, they get to collect more tax in a shorter period. As a result, the NIIT revenue has more than tripled since the tax took effect in 2013, rising from approximately $16 billion to more than $60 billion in 2021, and that number continues to climb. And that's according to the Internal Revenue Service, so we're not making up those numbers. That's straight from the source.

Over that period, the number of taxpayers owing it more than doubled, from about 3 million to around 7 million. Now, the 200,000 to $250,000 thresholds, had they been indexed for inflation, they would be closer to 264,000 330,000 000. So you can see that not indexing them for inflation is having a fairly significant effect on many, many taxpayers.

Higher yields on money market funds and taxable bonds, some are paying more than 5% right now, they're also pushing filers into this territory of NIIT. In fact, I can tell you that we talk to CPAs on a regular basis, sometimes every week, and they're consistently saying that every year they're seeing more of their clients being subjected to this surtax.

This tax is definitely a penalty for those who work hard to make above average income. I'm not saying stop working hard. I'm not saying don't make as much income. Simply saying, if there is such a thing as a penalty tax because you are successful, this is one of them.

As we always say, strategy is the key with all planning, and this is no different. With the right strategy, some taxpayers, you can avoid the 3.8% surtax. In worst case, really almost anyone can reduce it. So you want to listen to this next portion, because I'm going to talk about how we can do that.

First, let's talk about what income counts towards this 3.8% surtax. It applies to net capital gains on asset sales, including things like cryptocurrency, dividends, interest income, and that would include CDs and bank account interest, royalties, or even passive income. It also applies to net gains on the sale of a personal residence when it exceeds the $250,000 single filer exemption for capital gain or the $500,000 exemption for joint filers. If you're a landlord, rental income is also subject to this tax.

Now, what income doesn't count? Well, that would include wages, so your earned income. Pensions or Social Security, taxable retirement plan payouts aren't necessarily subject to the NIIT, but they can help trigger this tax, and we're going to talk about that in just a minute. Tax-free municipal bond income is also exempt. Now, income from actively managed businesses, such as partnerships or S corporations, those don't count either. So that's a good thing, but beware: the Biden Administration has made it clear they would like to change this part of the rule, and they be subject to the NIIT.

So let's talk about how the NIIT applies. Because investment income stacks on top of a filer's other income, things like wages, IRA withdrawals, it doesn't take much to push the investment income over that NIIT threshold. Let's look at a couple of examples. I think you will get my point.

First, let's assume that John and Joanna are retired. This retired couple has a $245,000 AGI from pensions and Social Security and their RMD, or required minimum distributions, from their IRA. They also have about 15,000 of taxable interest from their bonds and CDs and bank accounts. Now, because their income is $245,000, $5,000 of their interest is not subject to the NIIT, but $110,000 is, and that's because it's above, remember, their threshold of $250,000. That's where NIIT begins to affect this couple.

So because it's above their $250,000, this slice of income is going to raise the couple's 24% income tax rate to around 28%. That means they're going to owe about $400 more in tax. Now, that may not sound like a lot, but because the qualifying thresholds are not moving up with inflation, more and more of a couple's dollars could be affected by the surtax, and that means more money for Uncle Sam as we go down the road, fewer dollars in your pocket.

Now let's look at another example. Let's say that John is now a single filer. He has $175,000 of adjusted gross income, or AGI, from his wages, and he sells inherited stock with an $80,000 gain, and this would be to help, say, pay for his child's college tuition. He's going to owe NIIT on $55,000 of gains above that $200,000 of AGI. Remember, the single filer has a threshold of just $200,000 of AGI. That's going to raise his capital gain tax rate of 15% to approximately 9 18%, and that's going to add about $1,340 of tax. Now, this surtax of just 3.8% seems innocuous, but based on that second example, it can cost you a meaningful amount of money.

So how can we eliminate or at least reduce this tax? Tax-deductible contributions to traditional IRAs would be a good place to start, 401(k)s or health savings accounts. All of those help lower your adjusted gross income, and that in turn reduces the surtax. By contrast, Schedule A deductions like mortgage interest, medical expenses, and charitable deductions, or charitable donations, they don't reduce the NIIT, because they don't lower that AGI.

For older taxpayers, let's say that you're already into retirement taking required IRA payouts. If you're charitably minded, making donations using something called a QCD, or qualified charitable distribution, from your traditional IRA, this can make a huge difference. Do you know that you can give up to $100,000 of those IRA assets every year to one or more qualified charities, and that counts the donations toward their required payouts, and it's keeping that income out of AGI? So remember, $100,000 per year can be sent to your favorite charity, and that counts towards your RMD. You're making a great donation, and that income is removed from being part of your AGI. In other words, it never hits the tax return.

For savers considering converting traditional IRA assets to Roth IRAs, and this is a very popular thing right now, that 3.8% surtax can be a factor in favor of a conversion. Now, tax-free payouts from Roth IRAs, they don't raise your AGI or the 3.8% surtax, and there's no required distributions for the account owner. Once it's in a Roth, you don't have to make an RMD. So the conversion reduces those required payouts, and if you convert everything to Roth, it eliminates the required distributions. And if you're not sure about Roth conversion and whether it fits you, give us a call. We'll be happy to share more information to help you make a better decision.

Now, investors should also evaluate tax-free municipal bonds or muni bond funds. Those are tax exempt, and that means they are not going to be part of this surtax. Now, with higher yields, investors are getting paid more, and I am very happy about that. That's a good thing. On the other hand, it could be as simple as holding fixed income assets in tax-deferred retirement accounts to avoid this NIIT. So in this case, you might be able to have your cake and eat it too.

Let's round out our show with loss harvesting, another great tool or technique that can help offset taxable capital gains on the sale of profitable assets, and this includes the sale of a home with gains that might cross that threshold of 250,000 for a single filer or $500,000 for couples. Now, this loss harvesting can add one more benefit, and that is you can use these losses to offset tax on up to $3,000 of ordinary income, and you can do that each year if you don't use all of the losses. In other words, when you have losses that were not able to help you offset some of the gains or some of the ordinary income, they can be carried forward. That means you can use them in another tax year, so that's a nice benefit as well.

So there you have it, our take on net investment income tax, or NIIT. This nearly 4% tax, it can cost you a bundle, but it doesn't have to. Remember, taxes can be reduced with the right planning. So don't procrastinate. Get started, save some taxes to use towards your goals, not the goals of Uncle Sam. I hope this video has inspired you to review your tax situation in the coming months as we near the end of 2023. Make sure that you subscribe to our channel for more valuable tips and advice, and I'll see you next time on We're Talking Money.

Thanks for joining us on We're Talking Money. Be sure to visit us at omnistarfinancial.com, where you can learn more about how we provide value to our clients, subscribe to the show and our newsletters, and drop us a line with topic suggestions for upcoming shows. If you enjoyed the show, we would appreciate you passing it on to a friend and providing a rating on iTunes.

This podcast is a publication of OmniStar Financial Group. The content is developed from sources believed to be reliable and accurate with all information. The information in this material is not intended as tax or legal advice, may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals or specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security or service provided by OmniStar. All expressions of opinion reflect that of the authors and are subject to change. Any distribution, use, or copying of this podcast other than the intended recipients is prohibited.