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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