The 3.8% net investment income tax (NIIT) can negatively affect your estate plan. This is especially true if your assets include an investment portfolio, because the NIIT can increase the tax on your capital gains, taxable interest and other investment income, thus reducing the amount of wealth available to your family. In addition, the NIIT can be detrimental on certain trusts. 

The NIIT applies to individuals with modified adjusted gross income (MAGI) over $200,000. The threshold is $250,000 for joint filers and qualifying widows or widowers and $125,000 for married taxpayers filing separately. The tax is equal to 3.8% of 1) your net investment income, or 2) the amount by which your MAGI exceeds the threshold, whichever is less.

Suppose, for example, that you’re married filing jointly and you have $350,000 in MAGI. Presuming $125,000 in net investment income, your NIIT is 3.8% of $100,000 (the excess of your MAGI over the threshold, which is less than your net investment income), or $3,800.

Nongrantor trusts — with limited exceptions — are also subject to the NIIT, and at a much lower threshold: For 2020, the tax applies to the lesser of 1) the trust’s undistributed net investment income, or 2) the amount by which the trust’s AGI exceeds $12,950.

You can reduce or eliminate the NIIT by lowering your MAGI, lowering your net investment income, or both. Techniques for doing so include:

If you own an interest in a business, you may be able to reduce NIIT by increasing your level of participation. Income from a business in which you “materially participate” isn’t considered net investment income. (But keep in mind that increasing your participation may, in certain cases, trigger self-employment tax liability.)

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.

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.