IRS Form 8960 is used to report your Net Investment Income Tax. A relatively new tax created as part of the Obamacare legislation, the net investment income tax is a 3.8% tax on investment income for those with higher incomes. If your modified adjusted gross income exceeds certain limits depending on your filing status and you have investment income, you're subject to the tax. The income limits are:
- Married Filing Jointly: $250,000
- Qualifying Widow(er) with child: $250,000
- Single: $200,000
- Head of Household: $200,000
- Married Filing Separately: $125,000
These thresholds are not indexed for inflation, so even if the tax doesn't affect you today, it might over time as your income increases from work and/or investing.
What Form 8960 tells you
The way the Net Investment Income Tax works, you are charged that 3.8% on the smaller of:
- Your total net investment income, or
- The amount your modified adjusted gross income exceeds the limits listed above.
Much of Form 8960 is dedicated to helping you figure out how much of your income is subject to that tax. Once you've figured that out, it instructs you to multiply that amount by 0.038 to determine the Net Investment Income Tax you owe.
The complexity comes from the fact that not all of your investment income is considered "Net Investment" income for the purpose of the tax. For instance, money you withdraw from 401k, IRA, 403b, or pension plans isn't included. Similarly, life insurance death benefits, municipal bond interest, and any gain on your home sale that's excluded from capital gains taxes is also excluded from your net investment income.
Also, remember that the tax is levied based on your net income from investing, not your gross proceeds. If you sell $10,000 worth of stock in a taxable account that you paid $8,000 for, it's your $2,000 gain that's potentially subject to the tax, not the full $10,000 proceeds from the sale.
What can you do about the tax?
This particular tax is levied against your net investment income, and as an investor, you often have at least some level of control over what that amount is. For instance, if you own a stock that has appreciated since you purchased it, it is not considered a taxable capital gain until you sell it. Likewise, while dividends are included in your net investment income amount, if you hold your dividend payers in your IRA, those dividends are shielded from that tax both while you're compounding and while you withdraw.
Additionally, remember that while it's important to consider the total costs of any investment you make, it's also important to not let the tax tail wag the investing dog. As financially painful as it might be to owe more in taxes, if an investment isn't worth owning anymore, you're ultimately very likely better off taking the tax hit on a profit than you would be riding it down to a loss just to avoid the tax bite.
Instead, consider the tax as part of your cost of investing. Include the impact of the tax in any rate of return calculations you use in determining whether an investment is worthwhile to make, and consider it a transaction cost when figuring out which investments to close.
Whether you're selling based on valuation, considering a better opportunity, rebalancing for the sake of asset allocation, or taking money from your portfolio to live on, if you're affected by the tax, you need to understand what it means to you. Include it in the context of your overall reasons for closing your existing positions, and make your choices accordingly. That way, you'll give yourself the best chance of investing intelligently given the reality of the tax, without letting it dominate your decisions.