Which type of investment income is exempt from the Net Investment Income Tax?

Municipal bond interest is exempt from the Net Investment Income Tax (NIIT) because the tax was designed to target certain types of investment income that contribute to higher-income individuals' taxable income. Specifically, municipal bonds are issued by state and local governments and the interest earned on these bonds is typically exempt from federal income tax, making them particularly attractive to investors in higher tax brackets.

This exemption aligns with the broader tax policy goal of promoting investment in local and state projects, as it encourages individuals to invest in bonds that finance public initiatives without adding to their taxable income. In contrast, other forms of investment income such as dividends, nonqualified annuities, and income from passive activities are included in the calculation of net investment income and thus could be subject to the NIIT, depending on the taxpayer's overall income level.