Millions of high earners pay this investment income tax every year. Here’s how to avoid it

Higher earners are more likely to owe an extra levy on investment earnings than a decade ago. But there are ways to reduce your tax bill, experts say.

Enacted as part of the Affordable Care Act health-care expansion, the 3.8% net investment income tax applies to capital gains, interest, dividends, rents and more once your so-called modified adjusted gross income, or MAGI, exceeds certain thresholds. MAGI can be higher than adjusted gross income because it adds back the foreign earned income exclusion.

While dozens of tax code provisions adjust for inflation every year, the thresholds for net investment income tax have remained the same since 2013 — MAGI above $200,000 for single filers and $250,000 for married couples filing together.

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“It’s been around for a while, and the rules haven’t changed since it went into effect,” said Brian Schultz, a certified public accountant and partner at Plante Moran in Southfield, Michigan. “But the cost of inflation and incomes have trended up since then, so it’s become more of an issue.” 

An estimated 7.3 million taxpayers paid nearly $60 billion in net investment income tax in 2021, compared to 3.1 million taxpayers paying $16.5 billion in 2013, according to the Congressional Research Service.

It’s possible you may owe net investment income tax along with regular income taxes, explained certified financial planner Jim Guarino, a CPA and managing director at Baker Newman Noyes in Woburn, Massachusetts.

“Some folks refer to the net investment income tax as a type of stealth tax because taxpayers may not discover they owe this tax until they are preparing their income tax returns,” he said.

Here’s how it works. The 3.8% net investment income tax applies to the lesser of two thresholds: your actual net investment income, or your MAGI minus the net investment income tax threshold, he said.

For example, let’s say a married couple has a MAGI of $260,000 and $50,000 net investment income. The calculation would be $260,000 minus the $250,000 threshold, which means the tax applies to the $10,000 excess.

By comparison, if the same married couple has a $300,000 MAGI and $15,000 net investment income, the excess after subtracting the $250,000 threshold is $50,000. In this case, the tax applies to $15,000.

You can also trigger the tax from a one-time income boost, such as the sale of a business or home sale with profits above the capital gains exclusions, Schultz said.

Investors who may be subject to the tax may consider strategies like buying municipal bonds, which avoid federal taxes on interest and may bypass state and local levies, depending on where you live, he said.