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Passive Income Tax Rate in Details


When you look at the various facets of income opportunities available today, passive income is a much talked about alternative. But often, people are unaware of the exact tax rate and in the process, tend to miss out the advantages of the additional income.

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You must understand that the passive income tax rate is very different from nonpassive income. There are different types of rates applicable for different income opportunities. You can draw the biggest benefit from these income avenues by understanding your tax liabilities effectively and being able to service your needs and requirement accordingly.

Broadly, passive income tax can be deducted on passive income. By passive income, the US revenue department refers to all such earnings for which you do not have to earn or make any effort. It is income that follows its natural course as a result of any previous initiative that you might have undertaken. At the current moment, you do not have to do anything to maintain the steady cash flow, and therefore, this gets counted as passive income. There are, of course, many pre-requisites before you categorize the various income options. Therefore, it is pertinent that you understand the different provisions.

Passive Income Tax Rate & How to Determine It?

So it is important to understand what exactly passive income is and how you can distinguish it clearly.

1. Passive Income

In very simple terms, passive income refers to income or earnings from any activity where the beneficiary has not participated actively. The source of passive income could range from real estate to fixed deposit to business dealings as well. This could also include your earnings from certain investments at times. The crux of the arrangement is such that the beneficiary after the initial legwork can pretty much sit back and relax completely.

Now we all know that passive losses can be only claimed on the passive income tax liabilities. Most people now try to have simultaneous passive income sources apart from their active ones. This is exactly why special rules were constituted to put a cap on the amount of tax liability that you can seek to reduce through claiming passive income benefits.

These special rules that were enacted in 1986 specified that you can look at reducing your nonpassive income by as much as $25,000 if your overall income is less than $150,000. However, this also specifies your active participation in a passive income source like rent from real estate.

But beyond this point, you have to restrict claiming passive loss benefits from passive income. The losses that cannot be claimed can also be carried forward in consecutive years. You need to understand to offset the losses; you need to project passive income that can adequately account for this amount.

There are some instances where you can also use the proceeds of a sale to claim tax benefits for passive losses. But for that, you need to understand the law clearly and make provisions accordingly. This will make sure you are able to optimize the benefits of a separate passive income tax rate in the best possible manner.

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2. Portfolio Income

One of the most popular and interesting investment opportunities is undoubtedly that of portfolio income. In many ways, it can be considered passive income too as it comprises of various types of dividend, capital gains, interests and royalties. Though they are all clubbed together as either portfolio income or passive alternatives, the crux of the matter is that this kind of income has a very different tax rate. Different kind of portfolio income has different rates. For example, the tax rate for capital gains on an investment that you have held for over 12 months would be between 10-20%. However, if the capital gains are calculated on investment less than 12 months, then they are taxed at a regular rate. Social security taxes and medicare expenses are not levied on portfolio income. So whether you are trying to project your income as portfolio or passive, income will depend on several factors. But another benefit in case of portfolio income is you can use this to offset tax liabilities and other investment/income losses.

3. Active Income

This is often termed as earned income as well. It is what you would call as regular income opportunity. It is one of the easiest types of income and seen everywhere. You go to the office, earn money and come back. At the end of the month, there is salary in your bank account. As the name clearly indicates, this is active income because you are putting in the effort and getting the reward almost immediately.

It is needless to mention that this, of course, comes with the highest income tax rate. Personal taxes range anywhere between 10-35%, and apart from the direct income tax, there are several other taxes too that are levied on this income as well like social security and medicare taxes. Therefore the overall tax on this active income can be sometimes as high as 50%. Another point where this differs from passive income tax rate is the number of deductions. Well, the number of deductions is much less in this form of income as compared to other income opportunities like passive income or portfolio income.

So that further exacerbates the need to understand that various pre-requisites for what constitutes a passive income and then getting a fair perception of the exact tax rates. This is important also because the overall deductions that you can claim on a given year, and what losses you can carry forward to the next year is very closely linked to these factors in totality.

You must remember that understanding the various facets of your tax rate is as important as making sure you have a reasonable income source. This is because only a thorough understanding of tax will help you maximize your income potential and recover maximum value for every dollar that you earn. This understanding is also crucial in opening up various channels of investment in a constructive manner.

The Effort Element in Passive Income Tax Rate

When you look at the taxation rate of passive income Vs active income, one of the most striking elements to consider is the fact that why is earned income or active income come with a higher tax rate. Technically, you are putting in a lot more effort, devoting decidedly more time and even in terms of engagement, you need to have a far better and greater level of involvement. So how is it that you need to pay a greater amount of tax in return for your hard work.

Well, you have guessed it right, it is not the time that you devote towards generating passive income that matters but the point is how efficiently are you able to. In many ways, I would say that the tax department is perhaps telling you something really important. It is not important for you to work harder but on the contrary, you need to work smarter. Instead of devoting 8 hours in the office, if you can work at your convenience and generate an income that carries a lower tax rate, then why not? It will only work better in your favor.

I am sure you already understand by now what it really meant by passive income. It is, after all, any form of earning for which you do not have to put in any active effort. Effort or the lack of it is the key factor that distinguishes active from passive income.

One of the possible variants of this kind of income is dividend income. There are other popular alternatives as well. These include the likes of

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  1. Income from bank account
  2. Credit card reward points
  3. Royalties
  4. Licensing fees
  5. Rent from real estate

One of the unique features of passive income is it does not necessarily take into account how hard you work or how much effort you put in. Rather passive income capitalizes on how smartly you can execute a task. It is completely based on your ability how efficiently you can generate income without putting in a huge effort.

It doesn’t really matter how hard you are working or how many hours you have been devoting for the job. In fact, it celebrates the fact that you have put in some effort today and can then reap the benefits of it for the rest of your life.

What’s even better is there are many opportunities whereby you can also convert the active income into passive income. You can generate the cashflow that helps you take advantage of a far attractive tax rate. Once you are able to turn the active dollars into passive assets, it is needless to mention that you can then take advantage of the more liberal tax policy and look to conserve the cash a lot more effectively.

Why Passive Income Tax Works in Your Favor?

Perhaps I mentioned this already, but it does not hurt to repeat that the tax department’s policy is so geared that it shows a decided bias towards those who are working smarter instead of harder, in other words, it favors those who choose passive income options.

One of the best ways to claim this tax advantage is by choosing the most appropriate channel to generate the income. In this context, dividend income is one of the most lucrative opportunities. In fact, if you happen to fall within the 15% tax bracket, you can even enjoy the earnings from dividend absolutely free. This is because those individuals, who are within this specific tax slab, get taxed 0% on dividend income.

You might now ask what exactly comprises a 15% tax slab. Well, according to data available online if your annual average income is around $37,000 you qualify for this rate of tax. As per the existing policies, you can claim a standard deduction of not more than $6000, in case you are filing individually. On top of that, there are personal exemptions which you can claim close to $4000. On top of it, if you have a dividend income north of $47,000, you actually stand the chance of paying a big zero in income tax by the end of the year.

Now think about the tax rate at which you are earning at the moment. The disparity will be visible to you in very clear terms. But something that I missed out mentioning here is the social security and the medicare rates are still applicable on you. So you need to account for another 7.65% in tax as well. Apart from that, the tax rate still remains in favor of passive income

Therefore, it would not be wrong to term the passive income tax rate as one of the best representations of the ways to maximize the value of every dollar that you earn. It helps you to not just set long-term goals, but add more value to every penny that you set aside in the investment kitty. So whether you are planning to take an early retirement or compound your existing savings structure, the passive income tax rate can really come in handy in keeping the overall tax liabilities.

While setting long-term targets in one part of the story, the other important aspect is how well you can preserve this entire amount in a way that you pay bare minimum tax for it. It would mean that you will be able to retain the maximum amount of that money with you and not have to part with it as a tax liability.

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The Big Advantages of Passive Income Tax Rate

I am sure all of you understand by now what exactly is meant by passive income tax rate and the reason why passive income comes with a lower tax rate compared to other nonpassive opportunities to earn money for a prolonged period. But those opting for this kind of tax policy tend to make savings in many other unique ways as well. That also adds to the charm of opting for passive income and the associated tax rate that goes with it.

1. Limited Cost

If you follow the entire tax rate and way passive income tax is calculated, you will realize that there are no associated costs apart from what is already specified. Alongside, those who opt for this kind of income, also make a lot of savings in the form of lesser lunches outside, better time spent at home, lower wardrobe costs and far lesser transportation expenses. Now let’s face it that all of these services carry a certain amount of tax.

Whether you consider hospitality taxes, different kinds of surcharge and the rate of sales tax further exacerbates an individual’s tax liability over an extended period. You must understand in choosing a specific way of working often means that you can optimize the value of every dollar you earn or save in a comprehensive manner.

2. Flexible & Financially Secure

Let us explore the crux of the entire passive income dynamics. Why would you choose it over a conventional active income opportunity? Most times, this is because you get to decide the working hours, you are able to gain more time due to less travel, you inevitably spend more time at work, but at the same time, you are no longer financially dependent on anyone. Whether you are earning via rent income or dividend or any other type of passive income avenues, you are able to maintain your financial independence. A lower tax liability and ability to offset losses over wider time duration makes sure you would be tempted to choose this way of earning money more than any other.

3. You Are No Longer Tied to a Spot

If you have considered working from home ever, you would know that one of the most important reasons that people choose it over many other options is because they are then able to move freely. Most times, it is only internet connection and a laptop that they needed. When you consider passive income, the gains are even better. You do not have to work, you travel as much as you want and choose to stay wherever you want, yet enjoy the benefit of a steady cash flow every month. The icing on the cake is undoubtedly that your tax liabilities are also distinctly lower than what you would have to pay if you attended office every week and took bare minimum leaves. Plus, there is no certainty that you will have the job forever. You never know when you become a victim of a downsizing drive in office.

4. You Can Retire a Lot Earlier

Let’s understand we work, save, invest, work and continue this cycle for almost a lifetime in the hope of creating a cashflow that can sufficiently fund our requirements in a well-structured manner for our old age. But what if you can create that passive source without much ado and gain financial independence at a much lower age, perhaps 34-35?Moreover, it would mean that you also have to pay a lesser rate of tax and let’s face it; who does not want to take advantage of tax deductions? Moreover, if time is money, this is one of the biggest income sources for you. You save decidedly a lot of time, and that in itself can be a huge factor. That apart, you also have to pay lesser tax, so it is indeed a win-all strategy for you. The best part is you do not need to have a separate income source, you can easily convert your active earnings into passive income.

Some of the Key Passive Income Tax Rate That You Need to Know

Now let’s say; we have understood the great benefits of taking advantage of passive income tax rate, but then the question might come that how should you diversify the cash flow source? Should you depend predominantly on dividend income or can you also explore the option of bank deposit and earning interest for it? Here is a quick guide on the tax rate of some of the best known passive income sources and how you can get more value for every dollar that you earn.

1. Interest Income

This is perhaps one of the most basic forms of passive income. Hence, it becomes extremely important to understand the tax rate on this specific kind of income. Interest income essentially refers to all such income that you earn as interest from various financial institutions and banks. Whether it the interest that you earn from your savings account or the interest that your money market account yields, it is interest income. Interest from various deposits and bank certificates are also included in this list. Normally this interest, when credited to a specific account, is available for withdrawal. You do not have to pay any penalty and will be taxed as per your normal taxable income. The income tax rate, in this case, will range between 10-35% depending on the exact amount of your net income.

2. Dividend Income

This one is a very popular passive income source that is often recommended by analysts to generate steady cash. Essentially dividend refers to any periodic payment by stocks and mutual funds to their shareholders. This is not dependent on the market condition, and an individual can continue earning them as long as the stock or the mutual fund decides to pay to its shareholders.

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Broadly this dividend income is divided into two categories:

– Ordinary Dividend:

These are regular dividend payouts that you see in the market. The normal existing tax rate is levied.

– Qualified Dividend:

This refers to all those dividends that are paid on stocks that have been held for more than two months but within the 121 days post the dividend date or post the date the stock went ex-dividend. These are subject to a maximum tax accounting to 15% if regular or normal income tax rate of 25% in levied. In case, it falls below the 25% bracket, you are not liable for a single penny. It is absolutely zero.

3. Capital Gains

In the list of the most popular passive income channels, capital gains tax occupies pole position. Normally this refers to any kind of lump sum money that you might earn if you sell any major asset like stocks or mutual funds. Normally the amount you earn from the sale is much higher than what you paid for it initially. Capital gains again can have two primary variants:

  1. Short-term gains: This is the gain that you bag from asset sale that you have held for less than a year. These are taxed at the normal income tax rate that you are eligible for.
  2. Long-term gains: As the name suggests, this essentially refers to the profit that you earned from long-term holdings. The maximum tax rate for them is capped at 15%

4. Child Support

Marriages break, relationships suffer a jolt but what we don’t realize is these types of conflicts also have a financial implication. The money that a parent pays to the other parent or the child’s custodian for the proper upbringing is also passive income. This is not subject to income tax as opposed to alimony money that is taxed under regular tax rate depending on the bracket that you are under. Therefore the passive income tax rate on money received as child support is zero.

5. Social Security

The extent to which this kind of passive income is taxable is entirely dependent on the tax bracket under which you fall. Depending on your annual income, there are instances that not a penny of the social security retirement benefits is taxed. For those with income below $25,000 on an annualized basis, as single taxpayers, or below $32,000 when paid jointly, do not have to pay any tax on their social security benefits.

On an average, if you file as a single tax paper and your annual income is worth $34,000 or above $44,000 as a joint payer, almost 85% of this income is included in your regular income. This is then taxed at the normal rate that you are eligible for.

If your income is in between $25000-34000 as a single tax filer or between $32,000-44,000 as a joint taxpayer, 50% of the social security benefits will fall under the taxable income bracket.

Is Passive Income Tax Rate Complicated?

So I am sure you have understood by now that passive income tax rate is a rather complicated financial arrangement. You need to have a very clear perspective of the existing tax rate, the return prospects of various income channels and your ability to generate returns from a passive income source.

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Don’t get too buoyed by the lower tax liabilities for those with passive income. You must understand that while it is quite simple to enjoy the benefits of passive income, generating it at the initial stage needs a significant bit of legwork. You must be convinced about the channels that you choose.

That apart, you also need to make a ballpark assessment of the kind of money that you would require post retirement on an annualized basis. This will then be able to give you a clearer perspective on the kind of money that you need to generate and what type of passive income platform can help you best. It is needless to mention that you even need to take into consideration the various tax slabs and the rates applicable.

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Chris Pottorff

"Whether you think you can, or you think you cannot, you are right." - Henry Ford

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