The 3.8% Net Investment Income Tax: Who Pays It and How to Plan Around It

The NIIT was designed for high earners, but its thresholds have never been adjusted for inflation. For many Bay Area households, it now applies every year.

When it took effect in 2013, the net investment income tax was aimed at a narrow slice of taxpayers. More than a decade of wage growth later, a two-income tech household in Santa Clara County can exceed the thresholds on salary alone. The tax is modest in rate but broad in reach, and it interacts with equity compensation, stock sales, and rental property.

The basic mechanics

According to the IRS net investment income tax page, the 3.8% tax applies to the lesser of a taxpayer's net investment income or the amount by which modified adjusted gross income exceeds a threshold: $200,000 for single filers, $250,000 for married couples filing jointly, and $125,000 for married filing separately. These thresholds are fixed by statute and, as the Kiplinger capital gains guide notes, they are not indexed for inflation. The tax is computed on Form 8960 and paid with the regular return.

Net investment income includes interest, dividends, capital gains, rental and royalty income, and income from passive business activities. It does not include wages, self-employment income, distributions from IRAs and qualified plans, or Social Security benefits. The "lesser of" structure matters. A couple with $240,000 of wages and $50,000 of capital gains has MAGI of $290,000, which is $40,000 over the threshold, so the tax applies to $40,000, not the full $50,000 of gains.

Why equity compensation makes it bite

RSU income and NSO exercise spread are wages, not investment income, so they are not themselves subject to the NIIT. But they raise MAGI, which pushes investment income above the threshold. Consider a hypothetical single engineer earning $180,000 in salary with $120,000 of RSU vesting in a year. Her MAGI is $300,000 before any investment income. Every dollar of dividends, interest, and capital gains she realizes that year is fully exposed to the 3.8% tax, on top of the 15% or 20% federal capital gains rate and California's ordinary rates on gains. For a large sale of appreciated company stock, the combined marginal rate on the gain can exceed 35%.

The same dynamic affects the sale of a rental property or a tender offer. Timing large realizations into a lower-income year, where practical, can reduce or eliminate the NIIT on that income.

Planning considerations

Several approaches can reduce exposure, each with limits.

• Maximizing pre-tax retirement contributions lowers MAGI. For 2026 the 401(k) deferral limit is $24,500, with an $8,000 catch-up at 50 and $11,250 at ages 60 through 63; the cost is that withdrawals are later taxed as ordinary income.

• Health savings account contributions are also excluded from MAGI, with 2026 limits of $4,400 for self-only and $8,750 for family coverage, though only for those enrolled in a high-deductible plan.

• Tax-loss harvesting reduces net gains and therefore net investment income, subject to the wash sale rule and the $3,000 annual limit on net losses against ordinary income.

• Municipal bond interest is excluded from net investment income and from MAGI, which can make municipal bonds relatively more attractive for high-bracket investors, though yields are typically lower than comparable taxable bonds.

• Spreading a large sale across several tax years can keep some gains below the threshold in each year, at the cost of continued concentration and price risk in the meantime.

Roth conversions deserve a special note. A conversion is not investment income, but it increases MAGI in the year of conversion, potentially exposing that year's dividends and gains to the tax. Qualified Roth withdrawals in retirement, however, do not count toward MAGI, which is one reason the NIIT is sometimes part of the conversion analysis.

Rental property and real estate

Rental income is generally net investment income unless the owner qualifies as a real estate professional and materially participates, a demanding standard that most full-time tech employees cannot meet. Gain on the sale of a Bay Area rental is therefore usually subject to the NIIT. Gain on a primary residence is excluded to the extent it qualifies for the Section 121 exclusion, but any gain above the $250,000 or $500,000 limit is investment income.

Keeping perspective

At 3.8%, the NIIT is rarely the deciding factor in whether to sell a stock or convert an IRA. It is one more layer in the marginal rate, worth including in the estimate before a large transaction rather than discovering it the following spring. This article is educational only and is not tax, legal, or investment advice; readers should consult a qualified tax professional about their own situation.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.