Under the final regulations recently issued by the Internal Revenue Service (IRS), qualified plans and executive pay programs are generally exempt from the 3.8% net investment income tax (NIIT) on high-income individuals. The IRS also issued new proposed regulations to replace those issued in 2012.

Because most executive pay programs are not affected by the NIIT, employers might want to consider expanding deferral opportunities under these plans to enable executives to accrue earnings and receive income exempt from the tax. Also, since inside buildup on restricted stock before vesting, restricted stock units (or performance shares) before payment and stock options before exercise also can accrue without exposure to the NIIT, these programs might be more attractive.

Net investment income tax

The Patient Protection and Affordable Care Act (PPACA) added the 3.8% NIIT to the Internal Revenue Code. The tax applies to certain net investment income of individuals, estates and some trusts with income above the statutory threshold amounts. This article focuses only on the application of the NIIT to individuals.

Individuals are subject to this tax if they have “net investment income” and their modified adjusted gross income (MAGI) exceeds the following thresholds (not indexed for inflation):

Filing status

Threshold amount

Married filing jointly/qualifying widow(er) with dependent child

$250,000

Married filing separately

$125,000

Single/head of household

$200,000

For individuals whose MAGI exceeds the thresholds, the NIIT applies to the lesser of:

  • The amount by which MAGI exceeds the threshold
  • The amount of net investment income

Generally, for an individual, net investment income is the sum of the income items below, reduced by certain expenses allocable to the income:

  • Gross income from interest, dividends, nonqualified annuities, royalties and rents, except to the extent such income is excluded under the “ordinary course of a trade or business” exception in the regulations
  • Passive income from some trades or businesses, including those trading financial instruments or commodities
  • Net gain attributable to the disposition of property, such as capital gains (with some exceptions)

Law exempts distributions from qualified plans

In addition to exempting distributions from 401(a) qualified plans, 403(b) plans, individual retirement accounts (IRAs), Roth IRAs and 457(b) plans, the following are not subject to the NIIT:

  • Dividends on employer stock distributed to participants under Section 404(k)
  • Amounts treated as distributed for tax purposes, such as a Roth IRA conversion
  • Rollovers to an IRA or another qualified plan
  • Corrective distributions from a qualified plan or arrangement necessary to maintain its tax-favored status
  • Net unrealized appreciation attributable to employer securities that is realized on the later sale of the employer securities

Qualified plan distributions other than those from Roth IRAs or Roth 401(k)s are includable in income, however, so they will increase MAGI.

Nonqualified deferred compensation and other executive compensation arrangements

Amounts taxed as wages are excluded from net investment income. As a result, amounts paid to an employee under a nonqualified deferred compensation plan, including interest or other earnings, are not treated as net investment income.

Using the same logic, it appears that equity-based compensation would similarly be exempt from net investment income. For example, the following amounts should not be subject to the NIIT:

  • Stock options and stock appreciation rights at exercise
  • Restricted stock at vesting
  • Restricted stock units at payment
  • Performance shares at payment

Effective dates

The NIIT applies to taxable years beginning on or after December 31, 2012, while the final regulations generally apply to tax years beginning after December 31, 2013. For tax years beginning after December 31, 2012, and before January 1, 2014, the IRS will not challenge reasonable good-faith efforts to comply with the statute.