Net Investment Income Tax
for Trusts & Estates
Trusts and estates pay a 3.8% surtax on investment income starting at just over $15,000. Individuals do not pay it until $200,000. That gap is why distribution planning matters so much.
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Why trusts get hit so hard
The net investment income tax (NIIT) is a 3.8% surtax on investment income: interest, dividends, capital gains, and rental income. It applies to both individuals and trusts, but the thresholds are dramatically different.
For an individual, the NIIT does not kick in until income exceeds $200,000 (single) or $250,000 (married filing jointly). For a trust or estate, it starts at approximately $16,000, which is the point where the highest income tax bracket begins. That number adjusts slightly each year for inflation.
This means a trust with $20,000 of investment income is already paying the 3.8% surtax. An individual with the same income would not come close. It is one of the biggest reasons that keeping investment income inside a trust is so expensive.
Where the 3.8% surtax starts
What income is subject to the surtax
The NIIT applies to most types of investment income:
- Interest and dividends
- Capital gains from selling investments or property
- Rental income
- Royalties
- Passive business income
It does not apply to tax-exempt interest (like municipal bond income) or to income from a business that the trust actively operates. The distinction between passive and active business income can be significant for trusts that own rental properties or operating businesses.
The most effective solution: distribute
The NIIT only applies to undistributed net investment income. When the trust distributes income to beneficiaries, the income moves to the beneficiary’s tax return instead. If the beneficiary’s income is below the individual NIIT threshold ($200,000 or $250,000), the distributed income escapes the 3.8% surtax entirely.
The math almost always favors distributing. The gap between the trust threshold (~$16,000) and the individual threshold ($200,000) is so large that most beneficiaries can absorb significant distributions without triggering the NIIT on their own returns.
Of course, the trust can only distribute to the extent the trust document allows. Some trusts require all income to be distributed; others give the trustee discretion. For discretionary trusts, the NIIT impact should be part of the distribution decision every year.
The 65-day rule
There is a useful election called the 65-day rule (Section 663(b)) that can help with NIIT planning after the year has already ended.
Here is how it works: if the trust accumulated income during the year and the trustee realizes in January that the NIIT bill is going to be significant, the trustee can make a distribution within the first 65 days of the new year and elect to treat it as if it was made in the prior year. This reduces the trust’s undistributed net investment income for the prior year and lowers the NIIT.
The election has to be made on the trust’s tax return, and the distribution has to actually happen within the 65-day window. We flag this opportunity every year when it applies.
Capital gains: the tricky part
Capital gains are often the largest source of investment income in a trust, especially when property or investments are sold. Under most trust rules, capital gains are allocated to principal (the trust’s core assets) rather than income. This means they generally cannot be distributed to beneficiaries in a way that reduces the trust’s NIIT.
However, some trust documents give the trustee authority to allocate capital gains to income or to distribute them as part of principal distributions. If the trust document allows it, this can be a valuable tool for managing the NIIT. We review the trust document to determine what options are available.
When the trust runs a business
If the trust owns a business or rental property and is actively involved in managing it (not just collecting passive income), the income from that activity may be excluded from the NIIT entirely. This is called material participation, and it can make a real difference.
The rules for whether a trust “materially participates” are complex and not fully settled. Generally, the trustees themselves (not just hired managers) need to be regularly and substantially involved in the business. If this applies to your trust, we evaluate whether the material participation standard is met and document the activities to support the position.
What we handle
- Calculating NIIT on every trust and estate return
- Modeling the tax savings from distributing income vs. accumulating it
- 65-day rule elections to reduce NIIT after year-end
- Reviewing the trust document for capital gain distribution authority
- Material participation analysis for trusts that own businesses or rental property
- Coordinating NIIT planning with the overall distribution strategy
Frequently Asked Questions
What is the net investment income tax?
The net investment income tax (NIIT) is an additional 3.8% tax on investment income such as interest, dividends, capital gains, and rental income. It was created as part of the Affordable Care Act and applies to individuals, trusts, and estates. For individuals, it only applies when income exceeds $200,000 (single) or $250,000 (married filing jointly). For trusts and estates, the threshold is much lower: approximately $16,000, which is the point where the highest tax bracket begins.
Why do trusts pay the NIIT so much sooner than individuals?
Trusts and estates have extremely compressed tax brackets. The highest income tax bracket for a trust begins at approximately $16,000, compared to over $640,000 for an individual. The NIIT threshold for trusts is tied to this bracket, which means a trust pays the 3.8% surtax on investment income above roughly $16,000, while an individual does not pay it until income exceeds $200,000 or $250,000. This is one of the biggest reasons that keeping income inside a trust is so expensive from a tax perspective.
Can distributions to beneficiaries reduce the NIIT?
Yes. The NIIT applies only to undistributed net investment income. When the trust distributes income to beneficiaries, the income shifts to the beneficiary’s tax return. If the beneficiary’s total income is below the individual NIIT threshold ($200,000 or $250,000), the distributed income avoids the 3.8% surtax entirely. This is one of the most effective ways to reduce the trust’s overall tax burden.
What is the 65-day rule and how does it help with NIIT?
The 65-day rule allows a trust or estate to make a distribution within 65 days after the end of the tax year and treat it as if it was made in the prior year. This is useful for NIIT planning because if the trustee realizes after year-end that the trust accumulated more investment income than expected, a distribution in January or February can be applied to the prior year, reducing the trust’s undistributed net investment income and lowering the NIIT.