How to Avoid the NIIT
Each year more investors are surprised by a tax they didn’t plan for: the 3.8% Net Investment Income Tax (NIIT). Many investors think their long term capital gains rate is 20%, but for high earners it’s 23.8% because of the Net Investment Income Tax. It shows up quietly, and abruptly.
NIIT is a 3.8% federal tax that is part of the Affordable Care Act. You owe 3.8% on the smaller of your total net investment income, or the amount of your Modified Adjusted Gross Income (MAGI) that exceeds the threshold.
MAGI Limits
The MAGI limits are:
- Married filing jointly – $250,000
- Married filing separately – $125,000
- Single – $200,000
Where the NIIT Shows Up
The 3.8% NIIT applies to the following:
- Capital gains from stock sales
- Dividends
- Interest income
- Rental and royalty income
- Passive business income
- Non qualified annuity income
You can be taxed in so many different ways, and it can creep up on you.
How Tech Employees Activate It
NIIT frequently appears in situations that technologists often come across. For instance, you might pay NIIT in the following situations:
- When you sell large amounts of RSUs
- Get liquidity during an IPO
- Sell a concentrated stock position
- Realize large capital gains in taxable portfolios
- Receive venture capital or private equity distributions
Here a some examples to show how the Net Investment Income Tax works.
NIIT Triggered by Capital Gains
A married couple earns a $700,000 salary and realizes $800,000 in capital gains from huge gains from selling company stock.
Their MAGI is $1,500,000 ($700,000 salary + $800,000 capital gains). This is $1,250,000 above the $250,000 NIIT boundary.
The NIIT hits the lower of:
- Net investment income = $800,000
- Amount MAGI exceeds threshold = $1,250,000
In this scenario, the NIIT applies to the $800,000 capital gain. The NIIT is $30,400 ($800,000 × 3.8%).
Dividends Make You Pay the NIIT
A married couple earns $900,000 in salary and receives $200,000 in dividends.
Their MAGI is $1,100,000 ($900,000 salary + $200,000 dividends). This is $850,000 above the $250,000 borderline.
Remember the NIIT is the lower of:
- Net investment income = $200,000
- MAGI above threshold = $850,000
The NIIT amount is $7,600 ($200,000 x 3.8%).
Why This Matters
Many people don’t plan for Net Investment Income Tax until it shows up on their tax return. Then it’s too late!
The difference between 20% vs 23.8% in taxes on a large liquidity event can be meaningful. On a $1M stock sale, NIIT alone can add $38,000 of additional tax.
This is why good tax planning can help you reduce or avoid NIIT exposure.
Common strategies include:
- Tax-Loss Harvesting
- Income Timing Strategies
- Asset Location
Tax-Loss Harvesting
When you sell losing investments along with winning investments you can reduce your capital gains and NII tax exposures.
For example, you have $80,000 of capital gains and $40,000 of capital losses. When you combine both, the taxable gain is reduced to $40,000, cutting the capital gains tax in half, and potentially cutting the NIIT in half. The NIIT depends on your income.
Income Timing Strategies
You can manage your stock sales over multiple years to reduce NIIT exposure.
There are many ways to do this:
- Staggered stock sales
- Multi-year diversification plans
- Using 10b5-1 selling plans
Staggered Stock Sales
A staggered stock sale is a way to sell a certain number of shares per year. For example, you own 1,000 shares of your company stock. You sell 200 shares per year over the course of 5 years, no matter the share price. This is a simple and straightforward strategy.
Multi-Year Diversification Plans
Multi-year diversification plans are similar to staggered stock sales but a bit more complex. You can establish different options.
Instead of selling 200 shares per year, you can donate the shares to a Donor Advised Fund (DAF). Also, you can engage in some sophisticated strategies like covered call writing, exchange funds, 130/30 funds, direct indexing, and charitable remainder trusts.
10b5-1 Selling Plans
A Rule 10b5-1 plan is a trading strategy for company insiders. When you participate in this type of plan you buy or sell company stock according to a predetermined schedule.
For instance, you plan to sell 200 shares four times a year – January 15th, April 15th, July 15th and October 15th. The share sales are automatic. You get whatever price the shares are trading for that day.
Asset Location
You can use tax-advantaged or tax-free accounts for investments that generate income. For example, place high dividend paying stocks or bond investments into an IRA or Roth IRA account.
These accounts will defer (IRA) or be tax free (Roth IRA) and you won’t have to worry about the NIIT.
Wrapping It Up
Most investors focus on market returns. But many large portfolios are actually won or lost on tax efficiency. Thoughtful tax planning before a large stock sale can make a big difference in your tax return.
If you’re planning a large stock sale, diversification strategy, or liquidity event, tax planning ahead of time can significantly reduce surprises. If you’d like help thinking through strategies like tax-loss harvesting or diversification planning, let’s chat!