A little-known tax provision in the Affordable Care Act could negatively affect high-income earners who own annuities.

The Net Investment Income Tax (NIIT), which started this year as part of Obamacare, imposes a 3.8 percent tax on income from investments like gains from the sale of property and nonqualified annuities, among others.

While the NIIT only applies to certain taxpayers in higher income brackets (annual incomes exceeding $200,000), you may approach this tax bracket faster than you’d expect.

With your future income at stake and new changes in place, now is the time to review your investments and evaluate the taxes you may owe down the road.

Who Is Liable for the NIIT?

Before you start a complete overhaul of your investment portfolio, take a moment to determine if your earnings make you liable for this tax, either currently or at a future date.

First, the NIIT is based on your modified adjusted gross income (MAGI), an amount calculated by using your adjusted gross income (AGI), then adding certain items that would normally be deducted, like student loans and foreign housing. As you near retirement, your MAGI will include pensions, taxable IRA withdrawals, earned income, investment income and other factors.

Taxpayers affected by the 3.8 percent NIIT:

  • Single filers with a MAGI of $200,000
  • Married couples filing joint return with a MAGI of $250,000
  • Married taxpayers filing separate returns with a MAGI of $125,000

For example, a single filer with $100,000 in ordinary wages and $125,000 of investment income places them beyond the single filer threshold by $25,000. The NIIT on that overage (0.038 x $25,000) is $950.

The good news is only a small portion of nonqualified annuity holders with higher incomes will be responsible for this tax. A recent Gallup poll shows the number of nonqualified annuity holders who have a MAGI higher than $250,000 is less than 5 percent.

Types of Investment Income Affected by NIIT

Once you know if you qualify for this liability, you can determine if you have investments that will be taxed.

Here are some items included as investment income:

  • Taxable income from annuities
  • Taxable interest (not municipal-bond interest)
  • Dividends
  • Short and long-term capital gains
  • Rental income
  • Royalties
  • Income from the sale of a principal home above the $250,000/$500,000 exclusion
  • Net gain from the sale of a second home
  • Income from business activity where the taxpayer is not considered an active participant
  • Some Social Security benefits

Does This Apply to All Annuity Distributions?

Fortunately, this tax does not apply to all annuity holders. Only distributions from nonqualified annuities funded with after-tax dollars are considered investment income. Nonqualified annuities are those that are purchased with money from bank accounts, brokerage accounts or other assets.

When you receive payments from nonqualified annuities, only the earnings are taxed as ordinary income.

A qualified annuity is one set by an employer and funded with pre-tax dollars. Examples of tax deferred accounts include an IRAs, 401(k) or a 403(b) – also known as a tax-sheltered annuity or TSA plan.

Thinking About Buying an Annuity?
A financial expert can talk to you about your specific financial needs and recommend the type of annuity that is right for you.

Do Annuities Still Offer Benefits?

Annuities are still a useful investment vehicle – whether or not you are liable for the NIIT.

You will continue receiving tax advantages from annuities. While your annuity grows, before you receive payments, the earnings are tax-deferred. The principal amount you invest in an annuity will not be taxed. The only exception would be if it was purchased with pre-tax dollars.

There are also steps you can take to stay below the threshold amount for the NIIT.

Purchasing an annuity that will not pay you until after you have entered retirement and are no longer receiving income from your employer, which can help keep you below the threshold, is one way to minimize your tax liability during retirement.

Converting a traditional IRA to a Roth IRA may be a feasible solution for remaining below the threshold. You should always speak with a tax professional to help you balance investing in your future and knowing what to expect when tax time comes.

Even if you are not currently in the tax bracket facing this surplus, take a proactive step toward retirement by reviewing your portfolio and considering your future tax liability on your present investments.

Please seek the advice of a qualified professional before making financial decisions.
Last Modified: September 16, 2020