Published on: 09/22/2023
How Is Passive Income Taxed?
Passive income is often an essential piece of growing wealth and achieving long-term financial goals as long as you have strong tax strategies in place, but how is passive income taxed? Understanding how your different income streams will be taxed — and how to optimize them to lower this tax burden — is a vital part of developing an effective overarching financial strategy.
In addition to reducing tax liability, understanding how your passive income will be taxed is essential to ensuring compliance with tax laws. Because tax planning for high-net-worth individuals can be as important as managing the streams of income themselves, the fiduciary financial professionals at Avidian Wealth Solutions are here to discuss how passive income is taxed.
If you’re looking for tax planning strategies in Houston, have questions about how to lower your tax liability, or are interested in optimizing the overall performance of your portfolio, give the financial professionals at Avidian a call today to start a conversation.
What is passive income? How much tax do I pay on passive income?
In order to understand the difference between passive income and active income, we must first understand active income. Active income is income derived from a job or business venture that requires active participation. The IRS has rules for what it considers material participation in a business to differentiate between passive and active income.
An important distinction also needs to be made between passive and portfolio income. Portfolio income includes things like interest, dividends, annuities, and certain royalties and is not considered passive income.
Passive income is, therefore, income that was not earned through active participation in a business and does not always (according to the IRS) include interest and dividends. Although passive income is generally taxable, it is also often treated differently from active income by the IRS.
How is passive income taxed vs earned income?
Is passive income taxed at a lower rate? The IRS taxes passive income at the same rate as active income, with a few exceptions. Here are some examples of common passive forms of income and how their tax treatment varies:
- Rental income is taxed at the same rate as active income. This includes all rent, fees, deposits, or any other payments you receive related to the renting or use of a property. While the rental passive income tax rate is the same rate as active income, you can, however, deduct a significant amount of expenses from that rental income, including interest paid on mortgages, property taxes, operating expenses, and expenses related to maintenance.
- Stock dividends can either be taxed as normal income (if they are classified as ordinary dividends) or capital gains* (if they are qualified).
- Interest accrued from savings accounts is taxed from the withdrawable amount in the account in the year that you can receive the interest. These are taxed at the same rate as earned income.
As you can see, most passive income streams are taxed in the same way as active income streams, but there are often opportunities for tax breaks or exemptions depending on the
income stream or circumstance. Although the majority of passive income streams are taxed this way, there are, however, a few forms of passive income that are not taxed.
*Continue reading about the capital gains tax in Texas
What passive income is not taxed?
Untaxed passive income usually comes in the form of one-time payouts that do not happen regularly and cannot be relied upon as regular income streams. Some examples of untaxed passive income can include:
- Municipal bonds are tax-free at the federal level
- Inheritance is not federally taxed
- Life insurance policy payouts are tax-free
- Disability payments are often non-taxable
- Gifts under the annual gift tax limit ($17,000 in 2023) are tax-free
- Roth IRA withdrawals (as long as they are qualified) are usually tax-free
- HSA (Health Savings Account) fund distributions are tax-free
As you can see, since non-taxable passive income greatly depends on individual circumstances, investors are advised to focus on optimizing their finances by prioritizing the reduction of their tax burdens.
How to prepare your income for taxation
Just like taking advantage of favorable tax conditions available for passive streams of income, taking advantage of tax strategies should be consistent for all of your income streams. Some more common strategies for reducing tax liability include:
- Setting up a trust, making gifts, or paying into a life insurance policy can help high-net-worth individuals avoid the inheritance tax in Texas.
- Tax-advantaged accounts like IRAs and 401(k)s can provide tax benefits as well as returns on investments. Deductions from education spending accounts (like the Texas 529 tax deduction) can also provide significant tax-burden relief.
- Diversification of passive income streams can help to mitigate tax risks. Diversification and balance across asset classes and industries can help smooth tax obligations just as they help smooth investment risk.
- Qualified Business Income Deductions through the Tax Cuts and Jobs Act allow eligible business owners to deduct up to 20% of qualified income.
- Tax loss harvesting, or the process of selling investments at a loss to offset capital gains, can potentially reduce overall taxable income.
Those who want to take advantage of the tax benefits of passive income streams should remember that federal taxation remains applicable to most forms of passive income. If you want to make sure that you’re getting the most out of your multiple income streams, contact a trusted financial advisor for professional advice on how to guide you toward your goals.
Hoping to lower the tax burden on your passive income? Call Avidian today.
How is passive income taxed? While passive income is often taxed at the same rate as active income, passive income streams often have available tax benefits and remain an important tool for investors looking to grow their wealth and their legacy.
If you want to know more about the important link between taxes and wealth management and explore how tax benefits could benefit your overall financial plan, contact the wealth managers at Avidian Wealth Solutions.
Avidian offers a full suite of financial solutions to high-net-worth individuals, families, and business owners looking to optimize their wealth and simplify their lives. Avidian has offices in Houston, Austin, Sugar Land, and The Woodlands, full of fiduciary financial professionals ready to have a conversation about what we can do to help you work towards achieving your financial goals.
Ready to put plans in place that help you secure your wealth and simplify your life? Schedule a conversation with us today.
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