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

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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.

“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 with 3.1 million taxpayers paying $16.5 billion in 2013, according to the Congressional Research Service.

How the net investment income tax works

It’s possible you may owe net investment income tax along with regular income taxes, said 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, subtracting the $250,000 threshold from their MAGI leaves $50,000. So in this case, the tax applies to the $15,000 net investment income.

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.

‘Awareness and planning are integral’

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

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

You can also strategize about asset location, since certain assets, such as actively managed mutual funds, may have year-end distributions, Schultz said.

And for larger moves, such as Roth individual retirement account conversions, you may opt for several transactions spanning multiple years, rather than converting the entire balance in one year, he said.

This article was originally published by Cnbc.com. Read the original article here.