Tax on “Net Investment Income” (What Does the IRC Say?)

A reader writes in, asking:

I’m finding conflicting information about how the new 3.8% tax on net investment income is calculated. The lists for what types of income are included vary depending upon where I’m reading…WSJ, Forbes, etc. Even IRS articles don’t agree with each other!!

Whenever you’re getting conflicting information about a tax topic, I think the best approach is to go right to the source: the Internal Revenue Code (IRC).

While the IRC isn’t exactly fast-paced reading, I think you’ll find that it’s not (quite) as bad as you might have expected if you’re willing to be patient and take your time as you read it.

Finding the Appropriate Code Section

If you don’t know what you’re doing, it can be difficult to find the relevant code section for a specific topic. The method that works best for me is to use Google to do a site-specific search of Cornell University’s website (my favorite place to read code sections).

On Cornell website, all the Internal Revenue Code URLs start with “http://www.law.cornell.edu/uscode/text/26/”. So, to look for the code section about the tax on net investment income, I would start with the following Google search:

site:http://www.law.cornell.edu/uscode/text/26/ net investment income

Section 1411 is the first result. A quick glance tells us that we’re in the right place.

Making Sense of Legalese

As mentioned above, reading a section of the IRC is an exercise in patience. Fortunately, if you’re willing to go line-by-line, you can typically get a good enough grasp on the material to answer your specific question.

So let’s get back to our specific question: What is included in net investment income?

Section 1411 begins with the following statement:

“Except as provided in subsection (e)”

Darn. A cross-reference right off the bat. So we scroll down to subsection (e) and find:

“(e) Nonapplication of section
This section shall not apply to—
(1) a nonresident alien, or
(2) a trust all of the unexpired interests in which are devoted to one or more of the purposes described in section 170 (c)(2)(B).”

OK. That’s not so bad. Assuming you’re not a nonresident alien or dealing with a trust in some way, we can ignore this subsection and get back to our reading at the top of the page.

“In the case of an individual, there is hereby imposed […] for each taxable year a tax equal to 3.8 percent of the lesser of—
(A) net investment income for such taxable year, or
(B) the excess (if any) of—
(i) the modified adjusted gross income for such taxable year, over
(ii) the threshold amount.”

The structure of that statement isn’t particularly hard to understand. But it does leave the reader wondering about the definitions for “net investment income,” “modified adjusted gross income,” and “the threshold amount.”

And guess what? Subsection (b) consists of a definition of the threshold amount. Subsection (c) consists of a definition of net investment income. And subsection (d) consists of a definition of modified adjusted gross income. It’s almost as if this code section was written with the intention of being understandable!

So, to answer our reader’s question, let’s skip right to the part that defines net investment income:

The term “net investment income” means the excess (if any) of—
(A) the sum of—
gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),
(ii) other gross income derived from a trade or business described in paragraph (2), and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

So unless you’re deriving income from a trade or business, net investment income includes: interest, dividends, annuities, royalties, rents, and capital gains.

And a little bit later, in paragraph (5), we read the following:

The term “net investment income” shall not include any distribution from a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b).

You probably recognize 401, 403, and 457 as dealing with employer-sponsored retirement plans. Section 408 deals with IRAs, and 408A deals with Roth IRAs. In other words, net investment income does not include distributions from IRAs, Roth IRAs, or most employer-sponsored retirement plans.