BROWSE

Knowing the Tax Differences Between Active and Passive Income

Earning a steady income is a necessity if you have plans to support yourself and often requires trading your time for money.  However, not all income comes in the form of paycheck.  Rather, some assets that make money you’ve bought and do not require your active effort to earn it. This latter type of income, called passive income, can hold many advantages to active income.  In fact, many investors seek these income streams as a means to supplement their ordinary income (like that reported on a Form W-2 or a 1099 if as independent contractor) and offset their costs of living.   Doing so can also present a great opportunity to tell Uncle Sam to take less and not fork over quite as much money each year in taxes.

How Does Income Get Taxed in the U.S.?

In the U.S., the IRS oversees the tax code, which awards different tax treatment to income based on various factors.   A key distinction for this article comes from the treatment of income as "ordinary income" (i.e., wages and salaries earned from an employer or short-term capital gains realized from the sale of assets) or "passive income" (e.g., interest income, qualified dividend income, rental income, etc.). Ordinary income receives taxable treatment which uses 7 marginal tax brackets ranging from 10% at the bottom level of income to 37% at the top.  Following tax reform in 2018, this top tier fell from 39.6% to the new 37% rate. Passive income can prove more advantageous because it does not necessarily fall under the 7 tax brackets employed for taxing ordinary income or short-term capital gains.  It also helps for paying crypto taxes if you're selling a long-term capital gain in most instances. Instead, this income can experience more favorable rates under the same treatment as long-term capital gains, which go from 0% with certain levels of income to 20% on the high end. Aside from how the income is earned from these two sources (active vs. passive), the key tax differences between these two holding periods are the tax rates at which gains and income are taxed and the income levels at which the rates increase.   This post examines the tax advantages of qualified passive income sources and then reviews some common examples of those sources.

What is Active Income?

Active income acts as one of the most common types of income you receive because it comes through performing a service through a job, project, contract or other work arrangement. Included in this type of income are wages, salaries, tips, commissions and income from a business venture, employment or other form of active involvement earning the income. For the IRS to consider income earned from a business to be “active”, you must actively participate. We cover this more in-depth in the following section highlighting passive income. Active and passive income differ from portfolio income which includes money received from investments held in your portfolio. This entails any dividends, interest and capital gains received from your investments. If you have earnings from trading stocks on apps like Robinhood, Webull or other best stock trading apps, your earnings will fall into portfolio income. Though, it can be tricky to distinguish between portfolio and passive income. The reason for this is that passive income counts as a revenue stream which often requires an upfront investment to establish and receive payments down the line. Such examples include interest on savings accounts, money received from royalties, property rentals and more. Portfolio income, on the other hand, does not come from passive investments you make nor through regular business endeavors. Instead, it comes from dividends, interest and capital gains received from investments. Dividend-paying stocks and ETFs and writing options constitute portfolio income examples.

What is Passive Income?

When looking at the term, the definition might be self-evident.  Passive income is any income source which doesn’t come from active sources (also known as ordinary).  It is earned passively from other efforts in which you do not participate materially. There are several great examples of passive income ideas. Such examples of this include dividends, an interest held in a business as a limited partner, royalties earned on licensing rights, or even income earned from other investments in which the investor does not actively participate. In common practice, passive income has been referred to as income you earn in the background outside the regular wage income you bring home from work.   In other words, you don’t trade your time or effort to earn passive income.  For many who seek financial independence, a smart strategy includes building significant income from passive sources.  If done wisely, this can lead to early retirement and financial freedom. Equally as important as developing passive income streams is building those which enjoy tax advantages through taxation seen at long-term capital gains tax rates.  But to be clear, not all passive income is treated equally by the IRS. Because of this, the next section reviews some passive income examples and if they qualify for favorable tax treatment.

What Amount Can You Save in Taxes with Passive Income?

As mentioned above, the tax code taxes qualified passive income at long-term capital gains rates and not short-term like ordinary income.   This can result in significant tax savings because ordinary income tax rates progressively increase from 10% to 37% as you earn more money.  While the same progressive system exists for long-term capital gains and certain passive income, the rates range much lower from 0% to 20%. That’s correct.  Possibly as low as 0% and as high as 20%.  In comparison, it’s easy to see these rates can be significantly lower than the 10% to 37% seen with ordinary income.   Now that we can see the dramatic tax savings you can realize on long-term capital gains and certain passive income activities, we should now examine which activities qualify for this special treatment.   That way, you can use some proactive tax planning strategy to earn as much tax-advantaged income as possible.

Passive Income Examples

In practice, the most common example cited when discussing passive income that enjoys long-term capital gains treatment is qualified dividend income. If you can manage to earn qualified passive income in the top tax brackets, the difference in tax percentage is almost half (37% vs. 20%). At scale, these tax savings can result in a higher take-home amount of over your income and grant you the ability to meet your financial objectives easier.   If possible, and you can shift as much income to qualified passive sources, your savings can add up quickly.  Without much question, you can save a lot of money on your tax costs. Another popular example of passive income is municipal bonds.  These are debt instruments issued by state, city or local municipalities to fund investments for those jurisdictions.  They can also be issued by public agencies for financing needs. Municipal bonds cannot have federal income tax levied on their interest payments and are therefore popular with high-income taxpayers.  The lower tax burden on these financial assets make them attractive, but they also tend to pay lower interest rates than comparable corporate bonds as a result.   Another reason for these lower interest rates come from their lower perceived risk.  Because the debt is issued by a public agency, it is presumed the agency in question can raise taxes if the funds to repay do not appear sufficient.   Because of these primary determinants for lower interest rates, these types of bonds are best-suited to high-income investors who would stand to save the most on their taxes. Another example of passive income comes from rental real estate, also called rental income.  This income can come from renting a condo or apartment, commercial real estate, a vacation property, or other real estate options. Sadly, this income does not receive the favorable passive income tax treatment, despite not being actively earned income. The advantage of rental real estate is the rent payments come from your tenants whether work is done on your part to maintain the real estate or not. Further, you can claim accelerated depreciation and other relevant expenses to lower your taxable income earned from the property portfolio. In the eyes of the tax code, this income is considered passive but only under the passive income/at-risk rules by the IRS.   These state that if you have passive losses tied to owning and leasing a rental property, and earn between $100,000 and $150,000 per year, you can use these passive losses to offset your ordinary income up to $25,000.   This remains in effect after tax reform and the deduction phases out over that income range. As a final note for investors who recognize Section 1231 gains or losses on their disposition of rental real estate, they will need to report these on Form 8594: Asset Acquisition Statement if organized as a trade or business.

Conclusion

For the reasons laid out above, it is clear to see why investors prefer to hold assets which provide tax-preferred income like stocks which pay qualified dividends. These tax savings can quickly feed through to your bank account and result in long-term wealth creation and a more secure retirement. Done consistently and wisely and this can build generational wealth to pass down to your heirs.