Effective for 2013 and later tax years, Section 1411 of the Internal Revenue Code (Code) imposes a 3.8 percent net investment income tax (NIIT) on the net investment income (NII) of individuals, estates and trusts. The definition of NII is complex, but generally for an individual it is the net income from interest, dividends, annuities, royalties, rents and net capital gain. Certain income thresholds apply to individuals before the NIIT is imposed. The Internal Revenue Service recently issued final regulations on the NIIT.

Qualified Retirement Plan Distributions

Section 1411(c)(5) provides that NII does not include any distribution from a qualified retirement plan under Code Section 401(a), or from a Code Section 403(b) or 457(b) plan or an individual retirement account (IRA) (collectively, qualified plans). The final regulations under Section 1411 explain how this exclusion for distributions is applied.

The general rule is that an actual distribution from a qualified plan is not subject to NIIT. The regulations address several specific situations where the amounts are not NII, including:

  • Rollovers to an IRA or another qualified retirement plan
  • Corrective distributions, such as to correct a failure of the actual deferral percentage test or the actual contribution percentage test affecting a Code Section 401(k) plan; this provision should also apply to distributions as part of a compliance correction program
  • Deemed distributions from defaulted plan loans or from an in-plan or Roth IRA conversion
  • P.S. 58 cost of individual life insurance
  • Dividends on employer stock that are distributed to participants and deductible by the employer
  • Net unrealized appreciation (NUA) attributable to employer securities that is realized on the later sale of the employer securities

Once employer securities are distributed from a qualified plan, however, NII includes dividends paid on such securities and any appreciation in excess of the NUA that is realized on the sale of such securities.

Nonqualified Retirement Plans

NII does not include any amount that is taxable as wage income. Therefore, because all distributions from nonqualified retirement plans, such as SERPs and deferred compensation plans, as well as Code Section 457(f) plans, are taxed the same as wages, such distributions are exempt from the NIIT. However, these distributions are potentially subject to the new additional Medicare tax of 0.9 percent if the recipient’s income exceeds the threshold set for that tax.

Administration of Qualified Plans

The regulations clarify that the NIIT under Section 1411 should not affect the administration of any qualified retirement plan. Plan administrators do not need to take any actions based on the regulations.