Net Investment Income Tax (NIIT) 3.8%
The 3.8% Medicare surtax (NIIT) applies to high earners with investment income. Strategic planning—such as harvesting losses, maximizing retirement contributions, using installment sales, and converting IRAs to Roths—can reduce or eliminate exposure. Proactive planning not only lowers NIIT but also reduces federal and state income taxes.
How to Reduce Exposure to the 3.8% Medicare Net Investment Income Tax (NIIT)
The 3.8% Medicare surtax, also known as the Net Investment Income Tax (NIIT), can significantly increase tax liability for individuals, trusts, and estates with high levels of investment income or modified adjusted gross income (MAGI). Fortunately, proactive tax planning can help minimize or even avoid this surtax.
What Counts as Net Investment Income (NII)?
The NIIT applies to many forms of unearned income, including:
Capital gains from selling investments and real estate (including taxable gains from home sales).
Dividends, interest (excluding municipal bond interest), annuities, and royalties.
Passive income from rental real estate and businesses where the taxpayer does not materially participate.
Gains from selling passive partnership or S corporation interests.
Income from trading in financial instruments or commodities.
Certain income is exempt, such as wages, self-employment income, Social Security benefits, IRA and qualified retirement plan distributions, and tax-exempt bond interest.
Who Is Affected by NIIT?
You may owe the NIIT if your MAGI exceeds:
$200,000 (single filers),
$250,000 (married filing jointly), or
$125,000 (married filing separately).
The surtax applies to the lesser of:
Your net investment income, or
The amount your MAGI exceeds the threshold.
Key NIIT Planning Strategies
Tax planning should target either reducing investment income or lowering MAGI, depending on which drives your exposure.
Six Ways to Reduce Net Investment Income
Harvest losses by selling depreciated securities to offset gains.
Gift appreciated assets to children or grandchildren (watch out for the Kiddie Tax).
Donate appreciated securities to charity instead of cash.
Maximize deductions allocable to investment income.
Convert passive rental/business activities into non-passive through material participation.
Use installment sales or 1031 exchanges to defer capital gains.
Five Ways to Reduce MAGI
Harvest losses from taxable accounts.
Gift appreciated assets before sale.
Donate appreciated securities to charity.
Max out retirement contributions (401(k), SEP, defined benefit plans).
Defer business income and accelerate deductions (for cash-basis taxpayers).
Long-Term NIIT Reduction Tactics
Convert traditional IRAs to Roth IRAs (future distributions are NIIT-free).
Invest in tax-exempt bonds.
Use life insurance or tax-deferred annuities.
Invest in rental real estate or oil & gas ventures for tax-deductible offsets.
Favor growth stocks over dividend-heavy securities.
Examples in Action
Single filer (Ray): With $100k of investment income, strategies should focus on reducing net investment income.
Married couple (Sam & Toni): With $160k of investment income and $375k MAGI, strategies to reduce MAGI are most effective.
High-income couple (Victor & Wanda): Facing a $650k gain on a vacation home sale, they could use installment sales or a 1031 exchange to reduce or defer NIIT exposure.
Conclusion
The 3.8% NIIT can be a costly add-on to your tax bill, but careful planning offers multiple ways to reduce or avoid it. By coordinating strategies that lower both net investment income and MAGI, taxpayers can achieve double—or even triple—tax savings, including reductions in regular federal income tax and self-employment tax.