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 and non-passive income? ›
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 passive income and regular income? ›
Your job earns active income in the form of a salary, hourly wage, tips, and commissions. Active income means you are performing tasks related to your job or career and getting paid for it. Active income takes up your time. Passive income allows you to earn money with minimal effort.
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 the difference between passive and ordinary income? ›
Passive income is generally subject to different tax rules than ordinary income. For example, passive income may be subject to a lower tax rate, and losses from passive income activities can only offset other passive income rather than ordinary income.
What is a list of non-passive income? ›
Non-passive income can be derived from various sources. Wages, salaries, tips, bonuses, commissions and self-employment income are all examples. Each source represents a different form of active involvement, whether it's a traditional job, a freelance gig, or a personal business venture.
What qualifies as passive income? ›
Passive income is money you earn without actively working for it — as opposed to earned income from a job. In general, passive income comes from putting something you own — property, money or expertise — to work. The revenue you collect in rent, dividends or ad sales are all forms of passive income.
What is the tax rate for non-passive income? ›
Tax Consequences for Non-Passive Income
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.
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 social security considered passive income? ›
It's worth noting that some types of income could be considered passive income but aren't often associated with the term. Social Security is an example.
The Bottom Line
Passive investing is buying and holding investments with minimal portfolio turnover. Active investing is buying and selling investments based on their short-term performance, attempting to beat average market returns. Both have a place in the market, but each method appeals to different investors.
What is the difference between passive income and salary? ›
Active income is what you earn from your day-to-day job, where you trade your time for money. It's direct compensation for services rendered, such as salaries, wages, and business income. On the flip side, passive income involves earning without being actively involved on a daily basis.
What is the tax difference between passive and active income? ›
How they're taxed: Active income is often taxed at higher rates compared to passive income. For example, long-term capital gains and qualified dividends receive more favorable tax treatment than salary and wages, which are taxed as ordinary income.
What is the difference between passive income and non-passive? ›
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 and earned income? ›
Key Points. Earned income is the money you make in salary, wages, commissions, or tips. Investment income is money you make by selling something for more than you paid for it. Passive income is money you make from something you own, without selling it.
What is passive type 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.
How do I know if my K-1 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.
What is an example of a non-passive loss? ›
Common sources of nonpassive income and losses include: Business activity or trades that a person engages in during the tax year. Working interest in energy resources such as oil and gas. The working interest must be held directly or via an entity that does not limit liabilities.
Is self rental income passive or Nonpassive? ›
In the case of a self-rental, income is treated as nonpassive and loss is treated as passive.
What is the opposite of passive income mean? ›
Passive income is the opposite of active income. With active income, you are paid for the work you continuously do. Most careers or side hustles qualify as active income. With passive income, you do the work first, then collect payment over time—no further effort required.
