How to avoid net investment income tax for 2023

Higher earners are more likely to owe more tax on investment gains than they were a decade ago. But experts say there are ways to reduce your tax bill.

Enacted as part of the Medicare Expansion of the Health Care Act, a 3.8% net investment income tax is applied to capital gains, interest, dividends, rents, and more once it exceeds what’s called adjusted adjusted gross income, or MAGI, certain thresholds. MAGI can be higher than adjusted gross income because it adds the exclusion of foreign earned income.

While dozens of tax code provisions are adjusted for inflation each year, net income tax thresholds for investing have remained the same since 2013—MAGI’s exceed $200,000 for single applicants and $250,000 for married couples filing jointly.

More personal finance:
The lure of using an annuity is a guaranteed stream of income in retirement
Why it’s almost impossible to find a new car for less than $30,000
Chancellor says Supreme Court decision will have ‘adverse effect’

“It’s been around for a while, and the rules haven’t changed since they went into effect,” said Brian Schultz, a public accountant and partner at Plant Moran in Southfield, Michigan. “But the cost of inflation and income have trended higher since then, so it’s become a bigger problem.”

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

You’ll likely owe net investment income tax along with your ordinary income taxes, said certified financial planner Jim Guarino, a certified public accountant and general manager at Baker Newman Noyes in Woburn, Massachusetts.

“Some people refer to the net investment income tax as a type of stealth tax because taxpayers may not find out they owe this tax until they prepare their income tax returns,” he said.

Here’s how it works. A net investment income tax of 3.8% applies at least two thresholds: effective net investment income, or MAGI minus net investment income tax, he said.

For example, suppose a married couple has a MAGI of $260,000 and a net investment income of $50,000. The calculation would be $260,000 minus $250,000, which means tax applies to the $10,000 increase.

By comparison, if the same couple has $300,000 and net investment income of $15,000, subtracting $250,000 from their MAGI threshold leaves $50,000. So in this case, the tax applies to the net investment income of $15,000.

You can also collect the tax from a one-time increase in income, such as the sale of a business or sale of a home, at higher profits than the capital gains exceptions, Schultz said.

With many investors unaware of net investment income tax, “awareness and planning are integral,” Guarino said, noting that it can be a challenge for do-it-yourself tax preparers.

He said investors who may be taxed might consider strategies such as buying municipal bonds, which avoid federal taxes on interest and may bypass state and local fees, depending on where you live.