Investment Income Payroll Tax - Investment Friend

net investment income tax

Investment income and payroll tax are distinct aspects of the US tax system, each serving a different purpose and levied on different types of income. Investment income, generally, is not subject to payroll tax, although there are important nuances and exceptions.

Payroll tax primarily funds Social Security and Medicare. It’s generally comprised of two components: Old-Age, Survivors, and Disability Insurance (OASDI, often referred to as Social Security) and Hospital Insurance (Medicare). The OASDI portion is currently 6.2% on earnings up to a certain annual limit (the Social Security wage base, which changes each year). The Medicare portion is 1.45% on all earnings. These rates are applied to both the employee and the employer, meaning the total payroll tax for these programs is effectively double these rates. Self-employed individuals pay both the employee and employer portions, referred to as the self-employment tax.

Crucially, payroll taxes are levied on earned income. This generally includes wages, salaries, tips, and self-employment income. It’s income received in exchange for services rendered.

Investment income, on the other hand, encompasses profits from investments, such as:

Dividends: Payments made by corporations to their shareholders.
Interest: Income earned from savings accounts, bonds, and other debt instruments.
Capital Gains: Profits realized from selling assets (like stocks, bonds, or real estate) for more than their purchase price.
Rental Income: Income earned from renting out property.

Generally, none of these forms of investment income are subject to standard payroll taxes (Social Security and Medicare). They are, however, subject to federal income tax, and may also be subject to state and local income taxes. Capital gains and dividends may be taxed at different rates than ordinary income, often at lower rates, depending on holding periods and income levels.

The Net Investment Income Tax (NIIT) is a notable exception that can sometimes be confused with payroll tax. The NIIT is a 3.8% tax on certain investment income for individuals, estates, and trusts with income above certain thresholds. These thresholds are adjusted annually and are significantly higher than those for standard payroll taxes. The NIIT applies to the lesser of:

Net investment income, or
The excess of modified adjusted gross income (MAGI) over the threshold amount.

Net investment income for NIIT purposes includes interest, dividends, capital gains, rental and royalty income, and non-qualified annuities. It does not include wages, unemployment compensation, Social Security benefits, or certain other items.

In summary, while investment income is generally not subject to standard payroll taxes, higher-income individuals may be subject to the Net Investment Income Tax on certain types of investment income. Understanding the distinction between earned income and investment income, and the specific tax rules that apply to each, is essential for accurate tax planning and compliance.