4. Can conversion from a traditional IRA to a Roth IRA cause an individual to indirectly become subject to the NIIT?
Officially, distributions from traditional retirement accounts (IRAs, 401(k)s) are excluded from the NIIT. Similarly, amounts that are rolled over into Roth accounts from these traditional accounts are technically excluded. But these amounts still count in determining an individual’s AGI — and can cause the individual to exceed the applicable threshold and become subject to the NIIT.
As a result, for some individuals, Roth conversions are best exercised in small steps over time —converting only a small portion of traditional retirement funds each year to avoid crossing the AGI threshold. For others, Roth conversions may no longer be the best option for generating tax-free income during retirement.
5. How does the NIIT effectively increase the tax rate for capital gains and dividends?
The 3.8% net investment income tax is a surtax, meaning it is imposed independently on net investment income that is also subject to any other applicable income tax. To illustrate, the capital gains and dividend tax rate for taxpayers in the 39.6% tax bracket is 20%. However, if the taxpayer is also subject to the net investment income tax, there is an additional 3.8% tax imposed on those same capital gains and dividends. Thus, adding the two tax rates together, the overall effective tax rate for capital gain and dividends for those taxpayers is 23.8%.
For taxpayers who are not in the 39.6% tax bracket, the capital gains and dividend tax rate is only 15%. However, it is possible that such taxpayers with modified AGI that exceeds the threshold levels for the net investment income tax may also be subject to the net investment income tax. Adding the 15% regular income tax capital gain and dividend rate to the 3.8% net investment income tax rate, the effective rate of such taxpayers would be 18.8%.
Keeping reading for more net investment tax Q&As.