The key to effective financial planning are two primary types of income: Passive and non-passive. It’s important to understand both passive and non-passive income types that you may have and how each type affects tax planning for improved overall financial management. By mastering these, you will be better informed to strategically plan your finances and reduce tax liabilities. Talk to a financial advisor to learn about what you can do to reduce your tax liability on investments.
What Is Passive Income?
Passive income is money earned with minimal effort or active involvement. It’s income generated from investments, businesses or assets in which the earner is not actively participating on a regular basis. Passive income typically requires upfront time, effort or capital to create or acquire the income-generating source, but once established, it can continue to generate income with little ongoing effort.
Qualifications for Non-Passive Income
Non-passive income, often referred to as active income, is income earned through your active participation in work, services or business activities. This type of income is typically associated with traditional employment or actively running a business. Qualifications for non-passive income depend on the nature of the work or business, and they can include employment or offering services to others.
Qualifications for non-passive income can vary significantly based on the specific industry, profession, or type of work you’re engaged in. It’s important to research the requirements for your chosen career or business and take the necessary steps to meet those qualifications to ensure your income is earned through active participation and effort.
Tax Consequences for Non-Passive Income
Non-passive income earners have at their disposal a range of tax deductions and credits. These include the standard deduction, itemized deductions and tax credits for education, childcare and more. The tax rates for this income type are subject to regular income tax rates, which can range from 10% to 37%, depending on your income bracket.
Most people who are employed end up paying tax on non-passive income. While passive income might be subject to a higher tax rate, there is a potential for more ways to lower your taxable income, especially if your passive income is coming from a business. However, everyone’s situation is unique and it’s important to consult with a professional before making any decisions.
How to Avoid the Net Investment Income Tax
The Net Investment Income Tax (NIIT) is a 3.8% tax on certain investment income for high-income individuals. It was introduced as part of the Affordable Care Act and applies to taxpayers with modified adjusted gross incomes (MAGI) above specific thresholds. This tax applies to certain net investment income of individuals, estates and trusts with income above statutory threshold amounts.
There exist ample strategies, which may help minimize or avoid the Net Investment Income Tax. These incorporate investing in tax-exempt municipal bonds, channeling funds to retirement accounts and timing the sale of investments to manage taxable income.
Tips for Income Tax Planning
Sound tax planning extends beyond mere compliance with tax laws. It can lower your tax liability and help you extract the maximum benefits from available tax credits and deductions. Essential best practices in managing passive and non-passive income include:
- Know tax rules: Make sure you understand the tax implications of each income type you have.
- Keep detailed records: Keeping detailed records of your income sources can help you best prepare for the tax liability that is coming.
- Take advantage of tax breaks: Utilizing tax-advantaged investment vehicles whenever feasible can lower your tax liability and be used strategically, depending on your income.
Bottom Line
Grasping the differences between passive and non-passive incomes is a cornerstone for effective tax planning. Having unraveled the qualifications for these income types, and their respective tax implications, and proffered some useful tips for managing your income and tax planning, you are well-equipped to navigate your financial journey.
Tips for Tax Planning
- When you have multiple types of investments, it becomes vitally important to make sure you prepare your taxes accordingly. A professional advisor who specializes in taxes can be key to protecting your money in this way. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You may want to keep up to date with what you expect to pay in income tax every year. You can use SmartAsset’s free income tax calculator to estimate what you might owe.
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FAQs
In the world of personal finance, understanding the distinction between passive and non-passive income is incredibly important. Passive income is generated with minimal effort and offers financial freedom, while non-passive income often demands more active involvement.
What is the difference between passive income and non-passive income? ›
What Are Nonpassive Income and Losses? Nonpassive income and losses constitute any income or losses that cannot be classified as passive. Nonpassive income includes any active income, such as wages, business income, or investment income. Nonpassive losses include losses incurred in the active management of a business.
What is the difference between active and passive income answer? ›
Active income, generally speaking, is generated from tasks linked to your job or career that take up time. Passive income, on the other hand, is income that you can earn with relatively minimal effort, such as renting out a property or earning money from a business without much active participation.
What is an example of a non-passive income? ›
To gain a clearer understanding of non-passive income, here are four common examples:
- Wages and Salary. Perhaps the most common source of non-passive income is the income earned through regular employment. ...
- Investment Income and Dividends. ...
- Retirement Income. ...
- Social Security.
Gross income from passive sources includes: Dividends, interest, and annuities. Royalties (including overriding royalties), whether measured by production or by gross or taxable income from the property.
How do you know if K1 is passive or nonpassive? ›
Ordinary business income (loss) reported in Box 1 of the K-1 is entered as either Non-Passive Income/Loss or as Passive Income/Loss. The determining factor in whether the income should be reported as Passive or Non-Passive depends on whether the taxpayer materially participated in the business activities.
Can a rental property be non-passive? ›
In most scenarios, the IRS classifies rental income as passive income, but there are exceptions. If the rental property owner qualifies as a real estate professional by dedicating at least 750 hours yearly to real estate work, with over 50% of their overall work in real estate.
How do you know if your income is passive? ›
The IRS has specific definitions for passive income
For tax purposes, true passive income activities are either 1) “trade or business activities in which you don't materially participate during the year” or 2) “rental activities, even if you do materially participate in them, unless you're a real estate professional.”
Is passive income good or bad? ›
Passive income provides an additional earnings source and acts as a financial safety net. From cushioning against job loss to funding life's luxuries, the benefits of passive income extend far beyond having an extra paycheck.
What is the best definition of passive income? ›
Passive income is money that you don't have to actively work for; it comes in from something that already exists and continues to work for you. While active income is earned by working a job or owning a business, passive income is earned without having to work too much for it on an ongoing basis.
A second job. Getting a second job isn't going to qualify as a passive income stream because you'll still need to show up and do the work to get paid. Passive income is about creating a consistent stream of income without you having to do a lot of work to get it.
How to avoid paying taxes on passive income? ›
7 Ways To Grow Passive Income Without Paying Taxes
- Buy Tax-Free Municipal Bonds. ...
- Open a Roth IRA and Invest. ...
- Sell Your Home. ...
- Earn Long-Term Capital Gains. ...
- Collect Social Security Benefits. ...
- Get Disability Insurance. ...
- Invest In an HSA. ...
- Bottom Line.
While you don't have to work for your monthly Social Security checks, you did have to work to establish your Social Security benefit, so there's a bit of gray area here. But in many ways, Social Security and other retirement income sources like pensions can be considered passive income for most practical purposes.
What can offset passive income? ›
Passive activity loss rules state that passive losses can be used only to offset passive income. A passive activity is one in which the taxpayer did not materially participate during the year in question. Common passive activity losses may stem from leasing equipment, real estate rentals, or limited partnerships.
Is rental income passive or active? ›
In most cases, rental income is treated as passive income, even when an investor spends time overseeing a rental property business.
Why do people say passive income isn't taxed? ›
Passive income is named as such because it doesn't require any regular action on your part; once you have the stream established, it can mostly be set and forgotten. Generally speaking, passive income is taxed the same as active income.
What is legally considered passive income? ›
Passive income includes regular earnings from a source other than an employer or contractor. The Internal Revenue Service (IRS) says passive income can come from two sources: rental property or a business in which one does not actively participate, such as being paid book royalties or stock dividends.
What does passive income mean? ›
Passive income is money that you don't have to actively work for; it comes in from something that already exists and continues to work for you. While active income is earned by working a job or owning a business, passive income is earned without having to work too much for it on an ongoing basis.
