It is commonplace to have payroll taxes on wages. For years, employee salaries have been taxed 12.4% to Social Security and 2.9% to Medicare. Half of these taxes are paid by the employer, hidden from the employee outside of the payroll statement. The other half are visible to the employee and serve as federal garnishes on wages.

Social Security is often thought of as regressive. It has an earnings limitation where additional wages beyond this threshold are not subject to taxation.

Medicare, on the other hand, is now progressive. The Affordable Care Act of 2010 created the 0.9% Additional Medicare Tax, which applies only to employees earning over $200,000 in wages. The Additional Medicare Tax is calculated and reported on Form 8959, although your employer may have already collected some or all of this tax for you. When added to the 2.9% Medicare Tax, this brings the total Medicare taxation on wages over $200,000 to 3.8%.

Investment income is typically not subject to payroll taxation, but may this be a reminder that there is no guarantee our tax rules will make sense. Alongside the Additional Medicare Tax, the Affordable Care Act authors created the 3.8% Net Investment Income Tax (NIIT) as a Medicare contribution tax on investment income.

The 3.8% NIIT is applied to the smaller of investment income or the amount of taxpayer’s MAGI over a specific threshold. Those thresholds are $200,000 for individual tax payers and $250,000 for married tax payers.

You may notice that while the thresholds for the Additional Medicare Tax and the Net Investment Income Tax are similar, they are not identical. It is possible for married taxpayers to owe the Additional Medicare Tax on wages over the $200,000 threshold and not owe Net Investment Income Tax because their MAGI is below $250,000. This is just an oddity of the tax code.

Net Investment Income Tax is calculated on Form 8960. The calculation starts with the sum of:

• Taxable Interest
• Ordinary and Qualified Dividends
• Annuities
• Passive Income
• Capital Gain or Loss (not including sales from your home)

While many people are aware that it applies to capital gains, interest, and dividends, it is less widely known that it also applies to taxable annuities and passive income.

Nearly everything on Schedule C or E counts as either investment income taxed under NIIT or active self-employment income taxed under the Additional Medicare Tax. In this way, nearly all income on Schedule C or Schedule E is subjected to one of the two Medicare contribution taxes.

However, one interesting and intended consequence of these rules is for materially participating shareholders of S corporations . These S corporation employee owners have always been granted the ability to avoid self-employment tax on their shareholder distributions assuming that they are elsewhere receiving reasonable compensation from the S corp . To preserve this tax-advantaged treatment, S corp shareholder distributions which count as materially participating are excluded from investment income. In this way, the Additional Medicare Tax may apply to their reasonable compensation, but the Net Investment Income Tax would not apply to their shareholder distributions.

While this special treatment was intended by the original tax code authors, some politicians have been brandishing it as a loophole. This is another reminder of the fickleness of the tax code.

After calculating gross investment income, taxpayers are permitted to deduct investment expenses. Those include state, local, and foreign taxation attributable to the investment income as well as other miscellaneous investment expenses for tax years other than 2018 through 2025.

The Form 8960 instructions permit you to use a “reasonable method” to calculate what portion of those expenses is attributable to investment income. The instructions read:

Examples of reasonable methods of allocation include, but aren’t limited to, an allocation of the deduction based on the ratio of the amount of a taxpayer’s gross investment income (Form 8960, line 8) to the amount of the taxpayer’s AGI.

…Include state, local, and foreign income taxes you paid for the tax year that are attributable to net investment income.

For foreign taxation, note that “you may not take a deduction for any foreign income taxes paid for the tax year if you took a credit for any portion of them.” This means if you are claiming the foreign tax credit on Form 1116, then you should not claim foreign tax paid on Form 8960.

For state and local taxes (SALT), state sales taxes are explicitly not deductible for Form 8960. It is also implied that state real estate taxes are not deductible. However, state and local taxes which can be attributed to your investment income likely count.

Once your total SALT is calculated, the most common strategy to calculate the deduction is to prorate SALT between investment income and excluded income and then take the amount attributable to investment income as a deduction.

The total deduction is then subtracted from gross investment income to calculate net investment income on line 12 of Form 8960. The last step is to calculate Net Investment Income Tax by taking the smaller of your MAGI minus the threshold or your net investment income and then multiplying by 3.8%.

In this way, only net investment income which is over the threshold is taxable.

The thresholds are not inflation-adjusted and are:

Filing Status	Threshold Amount
Married Filing Jointly	$250,000
Qualifying Widow(er)	$250,000
Married Filing Separately	$125,000
Single or Head of Household	$200,000

 

For most taxpayers, modified adjusted gross income (MAGI) for the purpose of the Net Investment Income Tax is the same as adjusted gross income (AGI), though there are a few potential modifications in the Line 13 instructions.

All taxation on capital gains, including this one, creates economic problems. Capital gains taxation creates a hurdle which must be surpassed for realized gains to be worth it. This hurdle blocks the efficient allocation of capital, hurting the economy. This is one reason why the optimum rate for capital gains tax is always zero.

Alas, as is the theme of this article, our tax code was written by many different politicians with many different viewpoints over the years. There is no guarantee it makes sense or benefits anyone.

Photo by Jacek Dylag on Unsplash. Image has been cropped.