Net Investment Income Tax
A 3.8% federal surtax on investment income — including capital gains, dividends, and interest — that applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly).
What Is the Net Investment Income Tax?
The Net Investment Income Tax (NIIT), also known as the Medicare surtax on investment income, is a 3.8% federal tax imposed on the lesser of your net investment income or the amount by which your modified adjusted gross income (MAGI) exceeds the applicable threshold: $200,000 for single filers, $250,000 for married filing jointly, or $125,000 for married filing separately. Enacted as part of the Affordable Care Act, the NIIT applies to capital gains, dividends, interest, rental income, and other passive income.
For startup employees, the NIIT is relevant whenever you sell shares at a gain — whether from exercised stock options, RSU sales, or other equity dispositions. It effectively raises the top long-term capital gains rate from 20% to 23.8%.
How the Net Investment Income Tax Works
What Counts as Net Investment Income
For stock option holders, the most relevant categories of net investment income include:
- Capital gains from selling exercised shares (both short-term and long-term)
- Dividends from shares held
- Interest income (though less relevant to equity compensation)
Wages, salaries, and the ordinary income component of NSO exercises are not investment income for NIIT purposes — but they do count toward your MAGI, which determines whether the NIIT applies.
The MAGI Threshold
The NIIT is calculated on the lesser of (a) your net investment income or (b) your MAGI minus the applicable threshold. The thresholds ($200K/$250K) are not indexed for inflation, meaning more taxpayers become subject to the NIIT over time as incomes rise.
Example: You are a single filer with $180,000 in W-2 income and $300,000 in long-term capital gains from selling exercised stock. Your MAGI is $480,000. The NIIT applies to the lesser of $300,000 (net investment income) or $280,000 ($480,000 − $200,000 threshold). The NIIT is 3.8% × $280,000 = $10,640.
Interaction with Stock Option Income
When you exercise NSOs, the spread is ordinary income (W-2) — not investment income. But it raises your MAGI, which can push your investment income above the NIIT threshold. When you later sell the shares, the capital gain is investment income subject to the NIIT if your MAGI exceeds the threshold. This means a large NSO exercise in the same year as a share sale can trigger NIIT on the capital gains portion.
For ISOs with a qualifying disposition, the entire gain from exercise price to sale price is a capital gain and is subject to NIIT if your MAGI exceeds the threshold.
Practical Implications for Startup Employees
It Raises Your Effective Tax Rate
For high-income startup employees, the NIIT adds 3.8% on top of whatever capital gains rate applies. Combined with federal LTCG rates and state taxes, this can push the effective rate on stock option gains above 35–40% even with favorable long-term capital gains treatment.
Timing Capital Gains Events
If you have flexibility in when you sell shares, consider the NIIT impact. Spreading sales across multiple tax years may keep your MAGI below the threshold in some years, avoiding the NIIT entirely. This is particularly relevant for employees at newly public companies who are deciding how quickly to liquidate their holdings after the lock-up period expires.
No NIIT Escape Through State Choice
The NIIT is a federal tax and applies regardless of your state of residence. Moving to a no-income-tax state eliminates state taxes on capital gains but does not avoid the NIIT. The NIIT thresholds and rates are the same nationwide.
QSBS Exclusion Interaction
If your shares qualify for the QSBS exclusion under Section 1202, the excluded gain is not subject to the NIIT. The QSBS exclusion applies before the NIIT calculation, meaning truly excluded QSBS gains avoid both regular capital gains tax and the NIIT.
How It Relates to Exercising Stock Options
The NIIT is an additional tax layer to model when calculating the total cost of your exercise strategy. If you expect your MAGI to exceed $200,000 (single) or $250,000 (married filing jointly) in the year you sell exercised shares, budget for the additional 3.8% on your capital gains. Factor this into your comparison of exercise approaches and holding period strategies — it can add thousands of dollars to the tax bill on a large equity transaction.