The 3.8% net investment income tax (NIIT) can affect your estate plan in two ways: First, it can increase your tax on capital gains, taxable interest and other investment income, reducing the amount of wealth available to your family. Second, the tax is particularly harsh on certain trusts used in estate planning.

How it works

The NIIT applies to net investment income (NII) earned by “high-income” individuals. (See the sidebar “What’s your NIIT liability?”) It also applies to trusts and estates to the extent that their adjusted gross income (AGI) exceeds a surprisingly low threshold ($12,300 in 2015).

Investment income includes:

• Taxable interest,
• Qualified and nonqualified dividends,
• Short- and long-term capital gains (except on property used in an active trade or business),
• Rental and royalty income,
• Nonqualified annuity income,
• Income from passive business activities, and
• Income from trading financial instruments or commodities.

Investment income does not include:

• Wages, self-employment income, or income from nonpassive business activities,
• Tax-exempt interest (such as interest on municipal bonds),
• Distributions from IRAs or certain qualified retirement plans,
• Life insurance proceeds,
• Alimony,
• Social Security or veterans’ benefits,
• Gain on the sale of an active interest in a partnership or S corporation, and
• Nontaxable gain on the sale of a principal residence.

Planning strategies for individuals

For individual income tax purposes, you can reduce or eliminate NIIT either by 1) reducing your modified adjusted gross income (MAGI) below the threshold, or 2) reducing your NII. Strategies to consider (many of which reduce both MAGI and NII) include:

• Maxing out contributions to IRAs and qualified retirement plans,
• Deferring income through an employer’s nonqualified deferred compensation plan,
• Shifting investments into tax-exempt municipal bonds,
• Shifting investments into growth stocks that pay little or no dividends,
• “Harvesting” losses by selling securities at a loss and using them to offset gains,
• Investing in life insurance (cash buildup is exempt from NIIT and proceeds are excluded from both MAGI and NII),
• Purchasing individual stocks (as opposed to mutual funds) to obtain more control over the timing of capital gains,

• Transferring NII-producing assets to children or other family members in lower tax brackets,
• Using NII-producing assets to fund charitable donations, or
• Using installment sales to spread out income over several years.

Bear in mind that mutual funds typically distribute capital gains annually near the end of the calendar year or, in some cases, more than once a year. To minimize the impact of the NIIT, it’s best to avoid purchasing fund shares shortly before a fund makes a capital gains distribution.

Planning strategies for trusts

Given the low AGI threshold for trusts, income reduction strategies are of little value. But it’s important to understand that the NIIT applies only to a trust’s undistributed NII. One way to avoid the NIIT is to distribute all of its income to lower-income beneficiaries.

Understand that capital gains ordinarily aren’t included in a trust’s distributable net income (DNI), so they’re taxed at the trust level. Depending on state law and the trust’s language, however, it may be possible to include capital gains in DNI and, at least at the trust level, avoid NIIT on them. Of course, the beneficiary or beneficiaries of the trust may be subject to NIIT, so it’s important to plan accordingly.

You can also avoid NIIT by designing a trust as a grantor trust. Grantor trusts aren’t taxed at the trust level; rather, their income is passed through to you, as grantor, and taxed at your individual income tax rate. This strategy avoids NIIT on the trust’s investment income, but it may increase NIIT on your individual return, so be sure to evaluate its overall tax impact.

If you’ve established a nongrantor trust that holds rental real estate or other business interests, a recent U.S. Tax Court case may open the door to another strategy. The court ruled that it’s possible for a trust to “materially participate” in a business for purposes of the passive activity loss rules. If your trust satisfies material participation requirements, it’s possible to offset losses from these activities against nonpassive income, such as interest and dividends, reducing or even eliminating the trust’s NIIT liability.

Review your plan

As you review your estate plan, talk to your advisor about opportunities to reduce or eliminate NIIT. As always, tax planning is important, but it shouldn’t override other estate and financial planning considerations. Distributing a trust’s income to its beneficiaries, for example, may reduce its tax bill, but it may also defeat the trust’s estate planning purposes.

Sidebar: What’s your NIIT liability?

For individual income tax purposes, the net investment income tax (NIIT) applies to the extent that your modified adjusted gross income (MAGI) exceeds the following threshold:

Generally, MAGI is equal to your adjusted gross income (AGI), unless you live and work abroad, in which case you would add back the foreign earned income exclusion to arrive at MAGI.

The NIIT applies to the lesser of 1) your net investment income (gross investment income minus deductible investment expenses) or 2) the amount by which your MAGI exceeds the applicable threshold.