Net investment income (NII) is defined as the profit gained from investments after deducting certain related expenses. This includes various forms of income such as interest, dividends, rental income and capital gains. It’s essential to know not just what comprises NII, but also how it’s calculated and the tax implications it carries, especially for those with higher incomes who may be subject to the net investment income tax (NIIT). A financial advisor can help you navigate your investments and your potential tax obligations.
What Is Net Investment Income?
Net investment income (NII) refers to the profits that investors earn from their investments after deducting related expenses. As an example, let’s consider an investor who receives $100 in dividends from stocks and pays $10 in related brokerage fees. This would result in a net investment income of $90. Here are five common examples of NII:
You should note that other forms of income are not included in your NII. Here are five common examples of income that’s excluded:
- Wages
- Unemployment compensation
- Social Security benefits
- Alimony
- Tax-exempt interest
You may want to talk to your advisor and plan ahead before taking on new investments so you know what to expect and how it could impact your taxes.
How Net Investment Income Works
For the IRS, your NII measures various types of income earned from investments. As explained earlier, these can include interest, dividends, capital gains, rental income and passive income from businesses. The agency taxes this income to generate revenue and applies a surtax on certain high-income individuals to fund Medicare and other government programs.
Individuals, estates and trusts must pay a 3.8% net investment income tax (NIIT) when their NII goes over specific threshold amounts. For 2024, the NIIT is leveraged on the lesser of two amounts: your NII or the excess of your modified adjusted gross income (MAGI) over these three thresholds:
- $200,000 for single filers
- $250,000 for married couples filing jointly
- $125,000 for married individuals filing separately
Take note: When calculating your NII, certain deductions can get subtracted from your gross investment income. These may include investment expenses, interest paid on investment-related loans, and state and local income taxes directly related to investment income. But, not all investment-related expenses are deductible for NIIT purposes, and individuals should consult tax professionals or IRS guidelines for specific deductions.
How Realized Gains Can Be Earned
Realized gains are profits generated from the sale of an asset or investment, resulting in a tangible increase in value that can be recognized for tax or accounting purposes. These can be subject to the NIIT if they contribute to your overall net investment income and your modified adjusted gross income exceeds the threshold amounts defined by the IRS in the previous section.
You can earn realized gains when you sell an asset such as stocks, bonds, real estate, or other investments for a higher price than the original purchase one. These gains can stem from various market conditions such as appreciation in asset value over time, dividends received from stocks or mutual funds, or interest accrued on fixed-income securities.
Additionally, you can earn realized gains through strategic investment decisions, such as selling assets to lock in profits or rebalancing a portfolio.
All of these financial moves can have tax implications that are subject to capital gains tax at different rates depending on the holding period of the asset and your income level.
Investments held for more than one year are considered long-term and taxed at preferential capital gains rates ranging from 0% to 20%, depending on your income level. Gains from investments held under one year are classified as short-term and taxed at ordinary income tax rates, which correspond to your tax bracket.
You should also note that certain types of investments, such as collectibles and real estate, may be subject to different tax treatment.
Calculating Net Investment Income
You can calculate your NII by following these three general steps:
- Aggregate all forms of investment income, including interest, dividends, rental income and capital gains.
- Deduct allowable investment-related expenses, such as interest expenses, advisory fees and other costs directly tied to generating investment income.
- Maintain detailed records of all income and expenses to substantiate your claims in case of IRS inquiries.
Bottom Line
Your net investment income (NII) includes profits from various investment sources such as interest, dividends, rental income and capital gains. The IRS taxes your NII a net investment income tax (NIIT) to generate income. The agency will also apply a surtax to fund Medicare and other government programs if your modified adjusted gross income (MAGI) is above a certain level. Knowing how to calculate your NII could help you estimate your NIIT.
Tips for Tax Planning
- A financial advisor can help optimize your financial plan to lower your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Everyone has unique needs when it comes to tax planning. Consider these strategies to see if you could find ways to improve your overall tax outlook.
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