If you’re a high-income earner or business owner, you may have looked at your tax return and wondered, “Why does this number feel bigger than it should be?”. After accounting for income tax and capital gains tax, there are two additional taxes that get added to those with high enough incomes: Net Investment Income Tax and Additional Medicare Tax. While no one enjoys taxes, these two extra taxes can inflate your tax bill each year. Understanding what each tax is, how it works, and strategies around it can be yet another tax planning win for you.
Net Investment Income Tax
In 2024, single filers with income above $200,000 and married couples above $250,000 may be required to pay the Net Investment Income Tax (NIIT). This 3.8% tax is applied to capital gains, dividends, interest, rental income, and a few other income sources. Essentially, any “passive income” – or generally, income that is not tied to wages or self-employment income – may be subject to this tax. For higher-income households, this could start to add an extra tax in the magnitude of thousands of dollars.
Technically, when Modified Adjusted Gross Income (MAGI) is above $200,000 (single) or $250,000 (married), the NIIT is calculated based on the smaller of the net investment income or total MAGI above the threshold. Take for example, a married couple with $350,000 in income, and $50,000 of which is net investment income. All factors aside, NIIT would be 3.8% of $50,000, or $1,900. If a couple makes $275,000, of which $100,000 is net investment income, then 3.8% would apply to $25,000 (the smaller difference over the $250,000 threshold).
Unfortunately, the thresholds have not changed since the tax was instituted in 2013. Therefore, each year as inflation pushes incomes higher, more and more people will be subject to NIIT. Naturally, that leads to questioning what strategies can help minimize this tax. But first we must understand the sister tax to NIIT, the Additional Medicare Tax.
Additional Medicare Tax
While the NIIT is specifically targeted towards investment income, the Additional Medicare Tax is specifically targeted towards more “active” income. All wages currently subject to Medicare tax (think FICA), as well as self-employment income, are subject to the Additional Medicare Tax. This additional tax was also set up back in 2013 to help fund parts of the Affordable Care Act, like the premium tax credit.
Additional Medicare Tax thresholds are the same as the Net Investment Income Tax thresholds. Any single filer over $200,000 or couple over $250,000 will likely be required to pay this additional tax. Companies are required to automatically withhold extra money from employee paychecks once they make over $200,000. For business owners, it can become more complicated if you have both wages and self-employment income (think S-Corps). Once you are over the limit, the 0.9% tax is calculated similarly to the NIIT, based on wages over the threshold and not your entire wages.
Fortunately, both NIIT and the Additional Medicare Tax will apply to different incomes, so in theory, you should not have to pay both taxes on the same dollar of income. This is where a quality accountant can ensure you are paying the appropriate amount of tax, and only the amount you are required to. From there, broader tax planning strategies can be implemented to mitigate these taxes.
Strategies to Consider
One of the largest factors in determining your tax for these provisions is your MAGI, or Modified Adjusted Gross Income. In short, the more you can control your reportable income, the greater likelihood you have of minimizing these taxes and your taxes overall. How can you lower your income? Contributions to a retirement account, deferring income to a later year, or focusing on investments for growth that do not pay an income could be a few examples.
Take a married business owner with $300,000 in self-employment income. Setting up a new 401k plan and maxing out the $70,000 annual limit, they would drop their taxable income down to $230,000, below the threshold. For an owner with too much net investment income, the same strategy could apply. Moving $70,000 from a normal brokerage account into a tax-deductible account (like the 401k) would save 3.8% of $70,000, or $2,660 on taxes that year.
It could be the case that for owners with high net investment income, tax loss harvesting could be beneficial. Tax loss harvesting, when done correctly, can reduce your capital gains from year to year, effectively lowering your capital gains tax and therefore NIIT. However, those with most of their wealth in their business or through the income they receive may not have the taxable funds for such a strategy.
Pay Attention To Taxes
There has always been a lot of confusion around taxes. Especially once you hit higher income amounts and more taxes pile on. Working with an accountant who can explain your situation is vital. Then, working with an advisor focused on tax planning who can help you look forward in your financial plan to find ways to reduce your taxes is the next step. Many of the strategies can help optimize the “smaller” taxes like NIIT or the Additional Medicare Tax. 3.8% or 0.9% may sound like nothing, but over the years (especially as income increases), any savings could easily reach tens or hundreds of thousands of dollars.
TC Falkner 