CAPITAL IDEAS: Ways high-income earners can sidestep the hidden NIIT charge

Quick Summary

• A little-known 3.8 percent tax can cost high earners thousands of dollars. The net investment income tax, or NIIT, is not inflation-adjusted, so more taxpayers can become subject to it over time.
• Careful tax planning may cut or eliminate the extra levy. Tax-loss harvesting, eligible pretax retirement contributions, and donating appreciated securities can all help.
• Investment and withdrawal choices matter. Municipal bonds, tax-aware asset placement, qualified Roth IRA withdrawals, and well-timed Roth conversions can help limit NIIT exposure. Business owners and real estate investors may have additional ways to reduce the tax, especially when preparing for large asset sales.

High earners may be paying a hidden tax without realizing it. Even if you have never heard of NIIT, it could still apply to you.

That tax is the net investment income tax. You may see it on IRS Form 1040, Schedule 2, Part II, Line 12, or on IRS Form 8960. Even if you have not owed NIIT before, you might face it later. With planning, you may be able to reduce it or avoid it altogether.

A tax with a long reach

Congress created NIIT as part of the legislation financing the Affordable Care Act. It took effect in 2013. Although it is sometimes described as a Medicare tax, the revenue goes to the Treasury’s general fund.

Under current law, the rate remains 3.8 percent, with these household income thresholds:

Do not get hung up on the term “modified adjusted gross income,” or MAGI. For most households without special foreign-income adjustments, MAGI is simply adjusted gross income, or AGI. AGI is your total income minus deductions.

There is some good news. W-2 wages and bonuses usually are not counted for NIIT purposes. Withdrawals from retirement accounts such as IRAs or 403(b)s also are excluded. Social Security benefits and some tax-exempt municipal bond interest are excluded as well. Operating profits from a business are generally exempt if you materially participate in the business.

The drawback is that many common forms of income can still be subject to the 3.8 percent tax. That includes most dividends and interest outside retirement accounts, capital gains, rental income, passive business profits, and annuity earnings. Some capital gains from selling a business may also count. All of these make up your net investment income — the income that could be taxed. The key word is “could.”

NIIT applies to whichever is smaller: your net investment income or the amount by which your MAGI exceeds your filing-status threshold.

For example, if a married couple has $600,000 of MAGI, including $100,000 of net investment income, their income is $350,000 above the $250,000 threshold. But NIIT applies to the smaller figure, which in this case is the $100,000 of net investment income. At 3.8 percent, that creates a $3,800 tax bill.

Crossing the threshold does not mean all of their income suddenly becomes subject to the extra tax.

Use timing to your advantage

Take that same married couple with $600,000 in MAGI, including $100,000 in net investment income. If the investment income comes from selling stock they have held for years and they plan to retire at the end of the year, selling before retirement would trigger the $3,800 NIIT bill described above.

But if they wait until after retirement, when income has dropped, their MAGI might fall to $240,000. That would put them below the $250,000 threshold for joint filers, so the NIIT on the $100,000 capital gain would be zero.

Assuming the gain is taxed at the regular 15 percent federal long-term capital-gains rate in both years, their federal tax on the gain falls from $18,800 to $15,000. That lowers the effective rate from 18.8 percent to 15 percent. They still realize the $100,000 gain, but they keep an extra $3,800.

This illustration assumes the tax rules and investment gain remain unchanged and does not include state taxes. Before choosing to wait, it would also be wise to weigh the $3,800 savings against the risk of holding the stock longer.

Put investment losses to work

If income remains high, using existing investment losses may be more useful than waiting for a lower-income year. Realized capital losses can offset capital gains, reducing both net investment income and MAGI.

If $100,000 of losses offset gains that would otherwise be fully exposed to NIIT, you could save $3,800 on NIIT alone. You may also reduce regular capital-gains tax. The loss does not disappear, but it can still help shrink the tax bill.

Be mindful of the wash-sale rule. If you buy substantially identical securities within 30 days before or after a loss sale, you may lose the deduction. That can include certain purchases in a spouse’s account or an IRA. Pick a suitable replacement so you maintain market exposure without violating the rule.

Use deductions that actually count

Eligible pretax retirement-plan contributions can lower MAGI. Deductible health savings account contributions can also help if your household qualifies. Roth contributions do not reduce current income.

Returning to the married couple filing jointly with $600,000 in MAGI and $100,000 in net investment income: if they can make an extra $30,000 in eligible pretax retirement-plan contributions, their MAGI drops to $570,000, while net investment income stays at $100,000.

Those contributions can cut their regular income tax, but the NIIT bill remains $3,800. Their income is still far above the $250,000 threshold, so all $100,000 of investment income remains subject to the 3.8 percent tax.

Still, if a couple were closer to the threshold — say they had $275,000 of income and could make an extra $30,000 in eligible pretax retirement-plan contributions — their MAGI would fall to $245,000 and the NIIT would disappear because they would be below the cutoff.

Donate appreciated assets directly

If you are planning a charitable gift, consider donating appreciated shares that you have held for more than a year directly to a qualified charity. Selling first would realize a taxable gain. Donating the shares generally avoids that gain and may also qualify for a charitable deduction, subject to applicable limits.

A standard itemized charitable deduction does not reduce MAGI. That means the way you give can affect NIIT even when the charity receives the same value.

If you own an IRA and are at least 70 years and six months old, a qualified charitable distribution is another possibility. A direct transfer from an IRA to charity keeps the distribution out of taxable income and counts toward a required minimum distribution. That can help keep MAGI lower and shield other investment income from NIIT. Annual limits and other rules apply, and you cannot also claim a deduction for an excluded QCD.

Watch what your portfolio pays out

Interest from qualifying municipal bonds is excluded from net investment income and usually from MAGI. Treasury interest is federally taxable and generally still subject to NIIT, even though it is exempt from state income tax. Capital gains from selling municipal bonds can still be taxed.

That makes municipal bonds a useful option for some high earners. Before choosing them, compare after-tax yields, credit quality, and maturity. A tax break by itself does not guarantee the best result.

Where you hold investments matters too. Keeping taxable-interest holdings inside retirement accounts can shelter their earnings, while tax-efficient stocks may be better suited for taxable accounts. That is worth considering when adding new money or rebalancing.

Be strategic with retirement withdrawals

Qualified Roth IRA withdrawals do not increase MAGI. Using them for some expenses instead of taking more taxable traditional IRA withdrawals can help manage NIIT exposure.

Roth conversions require careful planning. The converted money itself is not counted for NIIT, but the taxable portion of the conversion raises MAGI in the year of conversion. It may make sense to separate a large conversion and a major stock sale into different years.

Business owners have more levers

Income from a qualifying business in which you materially participate is usually not subject to NIIT. That makes active participation important for owners, although the income still counts toward MAGI. Rental real estate has additional requirements; simply labeling yourself a real estate professional does not automatically make rental income exempt from NIIT.

For some real estate or private business sales, installment treatment can spread taxable gains over multiple years. These deals should be planned before the terms are finalized. The examples here use a $100,000 gain to make the 3.8 percent NIIT cost easier to see, but a larger sale, such as a $1 million business transaction, could create a much bigger NIIT bill if handled poorly.

What is happening in the stock market?

A recent trading session felt like a DeepSeek moment. As readers may recall, the stock market also fell sharply in January 2025 when DeepSeek, a Chinese open-source large language model, showed performance comparable to U.S.-based frontier labs such as Anthropic and OpenAI at a fraction of the cost.

On both of those days, the S&P 500 dropped by more than 1 percent and breadth, measured by the daily net advance/decline line, was notably positive, according to Bespoke.

There have been only 14 days when the S&P 500 fell by 1 percent or more while breadth was positive. Three of those cases were too recent to know what happened a year later. In the other 10 instances, the index was up an average of 2.07 percent over the next 12 months. That is good news mainly because the market was not lower. A 2.07 percent return is not especially strong, but it is better than a loss.

The less encouraging part is that those sessions have occurred only in two eras. One is the current AI boom. The other came at the end of the 1999-2000 dot-com boom, which is not exactly comforting.

Another caution: that 2.07 percent figure was only an average. In four of the 11 instances, the market was lower 12 months later, and three of those four declines were in double digits.

So should investors be nervous? Investors always seem to have something to worry about, and this is one more item on the list. Even so, I continue to hold equities. For all the talk of an AI bubble, some investors may take comfort in valuations. The S&P 500’s forward price-to-earnings ratio has eased to 18.7, below its 10-year average of 19.1, according to FactSet.

The last time the ratio was that low was in early April 2025, when the market was hit by tariff-related selling. By the end of that month, stocks had rebounded and the P/E had moved back to 19.0.