Qualified Plan Distributions Exempt from the NIIT
Beginning in 2013, a new 3.8% Net Investment Income Tax (NIIT) applies to the net investment income (NII) of high-income taxpayers. The tax is levied on single individuals with a modified adjusted gross income (MAGI) above $200,000 and on joint filers with MAGI over $250,000. The $250,000 threshold also applies to a surviving spouse. Married individuals who file a separate return have a $125,000 threshold. (MAGI is adjusted gross income plus any excluded net foreign earned income.) The amounts are not indexed for inflation.
NII generally includes gross income from interest, dividends, royalties, and rents; gross income from a trade or business involving passive activities; and net gain from the disposition of property (other than property held in a trade or business), reduced by deductions properly allocable to such income. The new tax applies to the lesser of total NII or MAGI over the applicable threshold. For example, if a couple has $200,000 of wage income and $100,000 of interest and dividend income (i.e., MAGI totaling $300,000), the NIIT applies to the $50,000 that is over the $250,000 MAGI threshold.
Distributions from the following types of retirement plans are not included in NII:
a. Qualified pension, profit-sharing, and stock bonus plans.
b. 403(a) annuity plans.
c. 403(b) annuities for employees of tax-exempt organizations or public schools.
d. IRAs and Roth IRAs.
e. 457(b) deferred compensation plans of state and local governments and tax-exempt organizations.
Example: IRA distribution exempt from NIIT.
Linda, a single taxpayer, has 2013 MAGI of $223,000, including interest of $3,350 and a taxable distribution of $26,000 from her IRA. Her income subject to the NIIT of $197,000 ($223,000 – $26,000) is under the $200,000 threshold. Therefore, Linda does not owe NIIT for 2013. However, the IRA distribution will be subject to ordinary income taxation and any penalty for early distribution (applicable, unless an exception applies).
Observation: If included in MAGI, qualified plan distributions may push the taxpayer over the threshold that would cause other types of investment income to be subject to the NIIT.
An individual with investable funds who is not contributing the maximum permissible amount to a 401(k) plan or IRA should consider doing so rather than investing the difference in a regular investment account. Not only will the individual get the income tax advantages of the qualified plan or IRA for the additional contributed amounts but, in the future, he or she may save some NIIT that could have been triggered had the funds been invested in a regular investment account.
Finally, the NIIT makes Roth IRAs more attractive. Qualified distributions from Roth IRAs are tax-free and thus will neither be subject to the NIIT nor be included in MAGI for purposes of that tax. Distributions from regular IRAs (except to the extent of after-tax contributions) will be included in MAGI, although they will not be subject to the NIIT.