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Understanding the Net Investment Income Tax Rate: How to Minimize Your Tax Bill

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Learn how the net investment income tax rate works and how to reduce your tax bill through proactive planning.

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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 (MAGI) exceeds the threshold for their filing status. For individuals, the threshold is $200,000 for single filers and $250,000 for married filing jointly.

Net investment income includes income from interest, dividends, capital gains, rental and royalty income, and nonqualified annuities. It also includes income from businesses involved in trading financial instruments or commodities.

Long-term capital gains tax and short-term capital gains tax are both subject to the net investment income tax rate. Capital gains tax triggers when an asset is sold for more than it was purchased for. 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.

If you hold an asset for more than one year before selling it, it's considered a long-term capital gain, and the tax rate is typically lower than the short-term capital gains rate. Long-term capital gains are usually taxed at 0%, 15%, or 20%, but can get as high as 28% for certain types of assets.

To minimize your tax bill, it's important to have a thoughtful tax strategy. For those that exceed certain income thresholds, proactive planning is all the more essential. Here are some tips:

  1. Harvest losses: If you have investments that have lost value, sell them to offset gains in other investments.

  2. Tax-loss harvesting: Sell investments that have declined in value to offset capital gains and reduce your tax bill.

  3. Invest in tax-efficient funds: Look for funds that have low turnover rates, which can reduce capital gains distributions and your tax bill.

  4. Consider tax-deferred accounts: Contributions to tax-deferred accounts like 401(k)s and traditional IRAs can reduce your taxable income.

  5. Plan charitable contributions: If you plan to make charitable contributions, consider donating appreciated assets instead of cash. You may be able to avoid the capital gains tax and still receive a tax deduction.

Congress hasn't made changes to rates on long-term capital gains and dividends for 2022 and 2023. However, governors and legislators have initiated income tax rate-cutting conversations in at least 18 states—and in about a dozen of those states, lawmakers have already passed rate cuts.

Learn about the tax proposals in the Biden Administration's just released $6.8 trillion budget proposal for fiscal year 2024. The proposal includes raising the top income tax rate to 39.6% for those earning over $400,000 and increasing the capital gains tax rate for those earning over $1 million.

In conclusion, understanding the net investment income tax rate and having a proactive tax strategy can help minimize your tax bill. By harvesting losses, investing in tax-efficient funds, and planning charitable contributions, you can reduce the impact of the net investment income tax on your portfolio. Keep an eye on legislative changes and proposals that may affect your tax bill in the future.

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