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Understanding the Net Investment Income Tax

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Explaining the purpose and impact of the NIIT on investors.

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Created as part of the Health Care and Education Reconciliation Act to fund healthcare reform in 2010, the net investment income tax (NIIT) is a tax on net investment income. Those who are subject to the tax will pay 3.8 percent on the lesser of the two: their net investment income or the amount by which their modified adjusted gross income exceeds the threshold amount.

The threshold amount is $200,000 for single filers and $250,000 for married couples filing jointly. Net investment income includes interest, dividends, capital gains, rental and royalty income, and passive activity income. It does not include wages, unemployment compensation, Social Security benefits, or alimony.

The NIIT applies to individuals, estates, and trusts that have net investment income and modified adjusted gross income above the threshold amount. It is important to note that the NIIT is in addition to any other taxes owed on investment income.

Like other earnings and realized gains on investments, dividend income is taxable. The tax rate on dividends, however, is dependent on a variety of factors, including the type of dividend (qualified vs. non-qualified), the investor's tax bracket, and whether the dividend is received in a retirement account or not.

The capital gains tax rate that applies to your gain depends on the type of asset, your taxable income, and how long you held the property. Short-term capital gains, or gains on assets held for less than a year, are taxed at the ordinary income tax rate. Long-term capital gains, or gains on assets held for more than a year, are taxed at a lower rate.

Every investor should have a thoughtful tax strategy, and for those that exceed certain income thresholds, proactive planning is all the more important. Tax-loss harvesting, for example, is a strategy that involves selling investments that have lost value in order to offset gains and reduce taxable income.

This week, the Bureau of Labor Statistics (BLS) released data showing that the consumer price index (CPI) rose 0.5 percent in January. This increase in inflation may impact the value of investments, particularly fixed-income assets like bonds. Investors may want to consider inflation-protected securities as a way to hedge against inflation.

Congress hasn't made changes to rates on long-term capital gains and dividends for 2022 and 2023. However, President Joe Biden will propose increasing the net investment income tax rate from 3.8% to 5% to help the Medicare program remain solvent. This proposal would impact high earners, particularly those who rely on investment income for their retirement.

In conclusion, the NIIT is a tax on net investment income that applies to high earners with modified adjusted gross income above the threshold amount. It is important for investors to have a comprehensive tax strategy that takes into account their investment income, capital gains, and dividend income. With the potential for changes to tax rates on the horizon, proactive planning is more important than ever.

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