Can a Trust Avoid the 3.8% NIIT? (w/Examples) + FAQs

Quick Answer

Yes — a trust can legally avoid or shrink the 3.8% Net Investment Income Tax (NIIT). For 2025, a trust pays NIIT once its adjusted gross income tops $15,650; for 2026 the figure is $16,000. By distributing income to beneficiaries, choosing the right trust type, or holding tax-exempt assets, the tax often drops to zero.

A trust hits the 3.8% surtax at a shockingly low income level. While a married couple does not owe the Net Investment Income Tax until their income passes $250,000, a trust crosses the line at just $15,650 in 2025 and $16,000 in 2026, per the IRS and Cannon Financial. That gap means almost any trust holding investments gets hit unless the trustee plans ahead.

The stakes are real. A trust that keeps $100,000 of dividends inside its own walls can owe roughly $3,200 in pure surtax on top of regular income tax that already climbs to the top 37% bracket at $16,000 in 2026, as noted by Katten. The good news: the law gives trustees several clean, legal levers — and most of them must be pulled before deadlines that arrive fast.

Here is what you will learn in this guide:

💡 The exact 2025 and 2026 income thresholds that trigger the trust NIIT, and why they are so much lower than the rules for people.
🏦 Which trusts are completely exempt from the tax, so you may already be safe.
📤 How distributing income to beneficiaries shifts the tax to their much higher thresholds — with the math shown step by step.
🗓️ The 65-day rule deadline that lets you reduce last year’s tax after the year already ended.
🧮 Three fully worked dollar examples that copy the IRS Form 8960 math so you can run your own numbers.

What the 3.8% NIIT Actually Is

The Net Investment Income Tax is a 3.8% surtax on investment earnings. Congress created it under Section 1411 of the tax code in the 2010 health care law, and it took effect in 2013, as the Journal of Financial Planning explains. It is separate from regular income tax. You can owe regular income tax and the NIIT on the same dollar of dividends.

The tax does not hit every dollar of investment income. Instead, a trust pays 3.8% on the smaller of two numbers, according to the Form 8960 instructions:

The trust’s undistributed net investment income for the year, or
The amount by which the trust’s adjusted gross income (AGI) tops the year’s threshold.

This “lesser of” rule matters because it creates two separate ways to win. You can lower the trust’s net investment income, or you can keep the trust’s AGI under the threshold. Either path shrinks the base the 3.8% is multiplied against. Often a trustee uses both at once.

The consequence of ignoring this rule is money lost every single year. The NIIT is not a one-time hit. A trust that accumulates investment income year after year pays the surtax year after year, quietly eroding the wealth meant for the family — the exact harm the trust was built to prevent. The first step for any trustee is to pull last year’s Form 1041 and check the trust’s AGI against the threshold to see if the trust is even exposed.

What Counts as Net Investment Income

Net investment income (NII) is the passive, money-from-money type of income. Per KahnLitwin, NII includes interest, dividends, capital gains, annuity income, rental and royalty income, and passive business income from activities the owner does not run day to day. These are the dollars the 3.8% tax targets.

Just as important is what is not NII. Wages, self-employment income, Social Security benefits, tax-exempt bond interest, and payouts from IRAs and qualified retirement plans are all excluded, per KahnLitwin. Active business income — where the owner materially participates — is also excluded, which becomes a planning tool covered later.

A common misconception is that all trust income is investment income. It is not. A trust that earns money from an active business it truly runs, or that holds municipal bonds, may have little or no NII at all. The reader’s first move is to separate the trust’s income into “investment” and “non-investment” buckets, because only the first bucket feeds the 3.8% tax.

Deductions That Lower the Base

The NIIT applies to net investment income after certain deductions, not gross income. Allowable deductions tied to investments include investment interest expense, state and local income taxes that relate to the investment income, and certain investment expenses, as the Journal of Financial Planning details. Up to $3,000 of net capital losses per year can also reduce NII.

The consequence of skipping these deductions is overpayment. A trustee who forgets to allocate state income tax or advisory fees against investment income reports a bigger NII than the law requires and hands the IRS extra 3.8%. The action step is to make sure the preparer allocates every eligible investment expense before the Form 8960 math runs, since these deductions are easy to miss and cannot be claimed later without amending.

Why Trusts Get Hit So Easily

Trusts face the NIIT at a threshold that is brutally low compared to people. The numbers tell the story.

Filer (tax year 2025)	NIIT income threshold
Single / Head of Household	$200,000 (Intuit)
Married Filing Jointly	$250,000 (KahnLitwin)
Married Filing Separately	$125,000 (KahnLitwin)
Trust or Estate	$15,650 (IRS)

For 2026, the trust threshold rises slightly to $16,000, while the trust tax rate also reaches the top 37% bracket at that same $16,000 mark, per Harris Beach Murtha. A married couple gets more than fifteen times the room a trust gets. This is not a typo in the law — it is the deliberate design Congress chose, and it is also not indexed the way you might hope across all entity types historically.

The consequence is that even a modest trust pays the surtax. Many trusts hold only investments, so nearly all of their income is net investment income, the Journal of Financial Planning notes. A small family trust with $40,000 of dividends already blows past the threshold and owes the tax on the excess. The reader’s takeaway: do not assume “my trust is too small to matter.” At these thresholds, small trusts matter most.

Which Situation Applies to You?

The right strategy depends on your trust type and your beneficiaries. Find your row, then read the matching section below.

You have a grantor trust (you pay its tax on your own 1040): You likely owe no trust-level NIIT — the income flows to you. Read “Trusts That Are Already Exempt.”
You have a complex trust that can accumulate income: Distributions are your strongest lever. Read “Strategy 1: Distribute Income.”
You have a simple trust that must pay out all income: Income already flows to beneficiaries, but trapped capital gains can still be taxed. Read “Strategy 5: Push Capital Gains Into DNI.”
Your beneficiaries are wealthy (already over their own thresholds): Distributions will not help much; focus on “Strategy 2: Tax-Exempt Investments.”
Your trust holds an operating business: Read “Strategy 4: Material Participation.”
The tax year already ended and you missed planning: You may still have time. Read “The 65-Day Rule.”

Trusts That Are Already Exempt

Some trusts never pay the NIIT at the trust level, no matter how much investment income they earn. Knowing your trust type can end the analysis before it starts.

The clearest example is the grantor trust. In a grantor trust, the person who set it up is treated as the owner for income tax, so all the income, deductions, and gains flow onto that person’s personal Form 1040, as SmartAsset explains. The trust itself does not owe NIIT. Instead, the income is tested against the individual thresholds of $200,000 or $250,000 — far higher and far friendlier than the trust’s $16,000.

Other exempt trusts include charitable remainder trusts, charitable trusts, and perpetual care trusts, per KahnLitwin. A charitable remainder trust is itself tax-exempt, though its NII can still carry out to the individual beneficiaries when they receive payouts.

A common misconception is that “grantor trust” means a tiny or informal trust. It does not. Many large, sophisticated trusts are intentionally drafted as grantor trusts precisely to keep income on the grantor’s return and dodge the low trust threshold. The action step: read your trust document or ask your attorney whether the trust is grantor or non-grantor, because that single fact decides whether the rest of this article even applies to you.

Strategy 1: Distribute Income to Beneficiaries

The most powerful move is to push investment income out of the trust and onto the beneficiaries’ returns. Here is why it works: when a complex trust distributes income, it claims a distribution deduction, and the income is taxed to the beneficiary instead of the trust, per the Journal of Financial Planning. The income is only taxed once — to the beneficiary, not the trust.

The magic is the threshold swap. Income that would face the 3.8% tax above $16,000 inside the trust instead gets tested against the beneficiary’s $200,000 or $250,000 threshold. If the beneficiary is below their threshold, the income escapes the NIIT entirely. This is the concept of distributable net income (DNI) — the mechanism that carries the trust’s income, and its tax character, out to the people who receive it.

The consequence of not distributing is paying the tax at the worst possible rate. A complex trust that hoards income pays both the top 37% income tax and the 3.8% surtax on the same dollars. A misconception here is that distributing always wins — it does not. If the beneficiary is already wealthy and over their own threshold, the distribution simply moves the 3.8% tax from the trust to the beneficiary and saves nothing. The action step: before distributing, estimate each beneficiary’s total income for the year so you only send dollars to beneficiaries who have room under their threshold.

Watch the Trust Document’s Limits

Distribution power is not unlimited. Many trusts restrict distributions to an “ascertainable standard” — health, education, maintenance, and support (HEMS) — and that standard may not allow a tax-driven distribution, the Journal of Financial Planning warns. A trustee who distributes outside the document’s authority breaches fiduciary duty and can be held personally liable.

The action step is to read the distribution clause before acting. If the document only allows HEMS distributions, the trustee may not be free to send income purely to cut the NIIT. In that case, talk to counsel about whether a beneficiary’s genuine needs justify the distribution anyway.

Mind the Kiddie Tax

Distributing to young beneficiaries has a trap. Children under 24 who are full-time students get hit by the “kiddie tax,” which taxes their unearned income at their parents’ rates, per the Journal of Financial Planning. Even so, income shifted to such a beneficiary can still dodge the 3.8% surtax if that beneficiary’s income stays under the $200,000 individual threshold.

The action step is to weigh both taxes together. A distribution might raise the child’s income tax through the kiddie tax while still saving the 3.8% NIIT — so run both numbers before deciding.

The 65-Day Rule: A Second Chance After Year-End

Here is the strategy most trustees do not know they have: you can reduce last year’s tax after the year already ended. Under Section 663(b) of the tax code — the “65-day rule” — a complex trust can treat distributions made in the first 65 days of the new year as if they happened on the last day of the prior year, per JD Supra.

The deadline is sharp. For a calendar-year trust, the 65-day window for the 2025 tax year ran through March 6, 2026, and the cash must actually move to the beneficiary by that date, per PP&Co. The election itself is made by checking a box on Form 1041, and it can be made as late as the extended filing deadline — September 30, 2026 for a calendar-year trust — but the payment cannot be late.

The consequences and rules are strict. The election is irrevocable once made, per the IRS regulation and WG CPAs, though a fiduciary may elect only part of the distributions in the window. A common misconception is that you can write the check on March 31 and still count it for last year — you cannot, because the hard payment deadline is the 65th day. The action step: calendar the 65-day deadline (around March 6 each year) and review the prior-year trust income before it passes, so you can still shift income out and below the threshold retroactively.

Strategy 2: Hold Tax-Exempt and Tax-Deferred Investments

What is never investment income cannot be taxed by the NIIT. Income that is exempt from regular federal tax — chiefly interest from state and local municipal bonds — is also excluded from the NIIT calculation, per the Journal of Financial Planning. The same goes for the build-up of value inside a life insurance policy.

The mechanism is simple: a trust that swaps taxable corporate bonds for municipal bonds converts NIIT-exposed interest into exempt interest. The trade-off is yield. Municipal bonds usually pay lower stated interest, so the trustee must compare the after-tax return of a taxable bond against the tax-free return of a muni before switching.

The consequence of mismatching this is lost yield for little benefit, or paying tax you could have avoided. A misconception is that munis only help with regular income tax — in fact they help twice for a trust, dodging both the income tax and the 3.8% surtax. The action step is to run a “taxable-equivalent yield” comparison, factoring in the trust’s combined 37% plus 3.8% rate, to see whether tax-exempt holdings beat taxable ones for this specific trust.

Deferral is the cousin strategy. A trust can use a Section 1031 like-kind exchange to defer gain on investment real estate, or a Section 1035 exchange to swap insurance and annuity contracts without triggering tax, per KahnLitwin. Deferring a gain keeps it out of this year’s NII, though the tax may return later when the asset is finally sold.

Strategy 3: Allocate Indirect Expenses Against Trapped Income

Trustees have flexibility in where they apply certain deductions, and used well, this cuts the NIIT. Under Regulation 1.652(b)-3, indirect costs like fiduciary fees, legal fees, and accounting fees can be allocated against almost any class of income, as long as a portion touches tax-exempt income, per the Journal of Financial Planning.

The smart move is to stack these indirect deductions against the investment income the trust is keeping — such as capital gains taxed to the trust — rather than against income being distributed. This shrinks the trust’s own net investment income and the 3.8% base. If the beneficiaries are also under their thresholds, both the trust and the beneficiaries can escape the surtax.

The consequence of careless allocation is a higher tax bill for no reason. A misconception is that expenses must be spread evenly — they need not be. The action step is to instruct the preparer to allocate indirect expenses to the trust’s retained investment income first, since that is where each dollar of deduction does the most NIIT damage in the trust’s favor.

Strategy 4: Material Participation in an Active Business

If a trust holds a business, the income may escape the NIIT entirely — but only if the trust is active in it. Income from a trade or business in which the owner materially participates is not net investment income and not subject to the 3.8% tax, per the Journal of Financial Planning. The catch is proving the trust materially participates.

Material participation means involvement that is regular, continuous, and substantial under Section 469. For a trust, IRS guidance such as TAM 200733023 and PLR 201029014 indicates the trustee must be the one who materially participates — the work of the trust’s employees alone does not count, and neither does a trustee who is merely an officer of the business, the Journal of Financial Planning reports.

The consequence of getting this wrong is that the business income is reclassified as passive and the 3.8% tax applies. A misconception is that simply naming a trustee who works in the business is enough — the IRS reads the rules narrowly. The action step, when a trust holds a large operating-business interest, is to appoint a trustee who genuinely and actively runs the business, and to document that participation carefully in case the IRS asks.

Strategy 5: Push Capital Gains Into DNI

Capital gains are the sneaky part of trust NIIT planning. Normally, capital gains stay locked in the trust’s principal (corpus) and are not carried out to beneficiaries through DNI. That means even a simple trust that distributes all its income still pays the NIIT on trapped capital gains, the Journal of Financial Planning explains.

There is a fix. Under Regulation 1.643(a)-3(b), capital gains can be included in DNI — and therefore distributed and shifted to beneficiaries — if the governing document and local law allow, and the trustee follows one of three consistent paths: allocating gains to income, treating them as part of distributions consistently on the books and tax returns, or actually distributing them to the beneficiary, per the Journal of Financial Planning.

The consequence of leaving gains trapped is paying the 3.8% on them at the trust level. A misconception is that capital gains can never leave a trust — they can, but only if the trustee sets up the treatment consistently from the start, not as a one-year scramble. The action step is to coordinate with counsel and the accountant to adopt a consistent capital-gains-in-DNI policy in the trust’s books before year-end, so the gains can ride out to beneficiaries who are under their thresholds.

Three Worked Examples (Run Your Own Math)

Numbers make this concrete. Each example uses the 2026 trust threshold of $16,000, per Ameriprise, and the “lesser of” rule from Form 8960.

Example 1: The Trust That Keeps Everything

The Harper Family Trust is a complex trust. In 2026 it earns $80,000 of dividends and interest and distributes nothing. Its AGI is $80,000.

Step 1 — Net investment income: $80,000 (all dividends and interest).
Step 2 — AGI over threshold: $80,000 − $16,000 = $64,000.
Step 3 — NIIT base is the lesser of the two: lesser of $80,000 and $64,000 = $64,000.
Step 4 — NIIT: $64,000 × 3.8% = $2,432.

By keeping everything inside, the trust owes $2,432 in surtax — on top of regular income tax that already reaches 37%. This is the worst-case baseline every other strategy improves on.

Example 2: The Trust That Distributes the Income

Same Harper Trust, same $80,000 of dividends. This time the trustee distributes the full $80,000 to one beneficiary, Maria, whose only other income is a $90,000 salary, leaving her total income at $170,000 — under her $200,000 single threshold.

Step 1 — Undistributed net investment income: $0 (all $80,000 was distributed and carried out as DNI).
Step 2 — Trust NIIT base is the lesser of $0 and ($80,000 − $16,000): lesser of $0 and $64,000 = $0.
Step 3 — Trust NIIT: $0 × 3.8% = $0.
Step 4 — Beneficiary check: Maria’s $170,000 total income is below her $200,000 threshold, so she owes $0 NIIT too.

The full $2,432 disappears. The income is still taxed once — at Maria’s ordinary rates on her 1040, which are lower than the trust’s compressed brackets — but the 3.8% surtax is gone for both parties.

Example 3: The Partial Distribution and the 65-Day Catch-Up

The Okafor Trust is a complex trust with $50,000 of interest in 2025 and an AGI of $50,000. The trustee forgot to distribute during 2025, but on February 20, 2026 — inside the 65-day window that closed March 6, 2026 — the trustee distributes $40,000 to a beneficiary under his own threshold and makes the Section 663(b) election.

Step 1 — Without the election: NIIT base = lesser of $50,000 NII and ($50,000 − $15,650 = $34,350) = $34,350. NIIT = $34,350 × 3.8% = $1,305.30.
Step 2 — With the 65-day election: the $40,000 is treated as paid in 2025, so undistributed NII drops to $10,000.
Step 3 — New NIIT base: lesser of $10,000 undistributed NII and $34,350 = $10,000.
Step 4 — New NIIT: $10,000 × 3.8% = $380.

The retroactive distribution cut the surtax from $1,305 to $380 — a $925 saving — even though the tax year had already closed. This is the power of the 65-day rule when you catch the deadline.

Common Mistakes That Cost Trusts Money

Even informed trustees slip. Watch for these specific errors.

Assuming the trust is too small to owe NIIT. At a $16,000 threshold for 2026, almost any investing trust is exposed, per Cannon Financial. The fix is to check the trust’s AGI against the threshold every year.
Missing the 65-day deadline. Distributions for the prior year must reach the beneficiary by roughly March 6, per PP&Co. Calendar it now.
Distributing to wealthy beneficiaries. Sending income to a beneficiary already over their own threshold just relocates the tax, the Journal of Financial Planning notes. Distribute only to beneficiaries with room.
Forgetting trapped capital gains. Gains stuck in corpus still get taxed unless a consistent DNI policy is in place under Reg. 1.643(a)-3(b).
Distributing outside the trust’s powers. A HEMS-only document may bar tax-driven distributions, per the Journal of Financial Planning. Read the document first.

What to Do Next

Start with one question: is your trust a grantor or non-grantor trust? If it is a grantor trust, the income lands on the grantor’s 1040 and the trust-level NIIT usually vanishes, per SmartAsset. If it is non-grantor, pull the latest Form 1041 and compare the trust’s AGI to the $16,000 threshold for 2026.

If the trust is exposed, model a distribution to beneficiaries who sit below their own $200,000 or $250,000 thresholds, then layer on tax-exempt holdings and smart expense allocation. Finally, mark the 65-day deadline on your calendar so you keep the option to fix the prior year retroactively. Because the surtax interacts with fiduciary duties and your trust’s specific document, run any plan past a CPA or estate attorney before you act.

FAQs

Do grantor trusts pay the 3.8% NIIT?

No. In a grantor trust, the income flows to the grantor’s personal return, so the trust itself does not owe NIIT, per SmartAsset. The income is instead tested against the grantor’s individual thresholds of $200,000 or $250,000 — far higher than the trust’s $16,000 for 2026.

Are capital gains inside a trust subject to NIIT?

Yes, usually. Capital gains are net investment income and are taxed at the trust level when they stay in corpus, even in a simple trust, per the Journal of Financial Planning. They can be shifted to beneficiaries only if the trust consistently includes them in DNI under Reg. 1.643(a)-3(b).

What is the trust NIIT threshold for 2025 and 2026?

The threshold is $15,650 for 2025 and $16,000 for 2026, per the IRS and Ameriprise. A trust with AGI below that figure owes no NIIT at all.

Can distributing income really eliminate the trust’s NIIT?

Often, yes. Distributions carry the investment income out to beneficiaries, who are tested against their much higher thresholds, per the Journal of Financial Planning. But it only saves tax if the beneficiary is below their own $200,000 or $250,000 threshold; otherwise the tax simply moves to the beneficiary.

Is municipal bond interest taxed by the NIIT inside a trust?

No. Tax-exempt interest from state and local bonds is excluded from net investment income, so it escapes the 3.8% surtax, per the Journal of Financial Planning. It also avoids regular federal income tax, giving trusts a double benefit.

When is the 65-day rule deadline?

For a calendar-year trust, distributions for the prior tax year must reach the beneficiary within 65 days — about March 6 — and the Section 663(b) election is then made on Form 1041, per PP&Co. The election is irrevocable once made, per WG CPAs.

What form does a trust use to report the NIIT?

A trust reports the Net Investment Income Tax on Form 8960, attached to its Form 1041, per the Form 8960 instructions. The form walks through the “lesser of” calculation between undistributed NII and AGI over the threshold.

Does a charitable remainder trust pay NIIT?

No, the trust itself is tax-exempt, per KahnLitwin. However, the net investment income can carry out to the individual beneficiaries through their payouts, where it may be taxed on their personal returns.

This article is general information, not tax or legal advice. Trust taxation depends on your specific document, state law, and facts. Consult a qualified CPA or estate-planning attorney before acting.

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