Most people’s income comes as the direct result of work — you get a job, show up, hopefully perform decently well and then money shows up in your bank account. Some people, though, look to set up streams of passive income — money that flows into your account regularly that doesn’t require any direct work. As with any income, though, there are tax implications for potential passive income streams. Here’s how it works.
If you would like professional help developing a comprehensive investment plan, consider working with a financial advisor.
What Is Passive Income?
Passive income is also often called unearned income, which differentiates from earned income — money you get from working for a company or yourself. Common forms of passive income are earnings from rental properties, returns on investments and interest on savings accounts.
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.
Passive Income and Taxation
Generally speaking, passive income is taxed the same as active income. However, the exact tax treatment will depend on the exact source of your passive income and your financial situation as a whole. Let’s take a look at three examples.
- Rental properties: Rental income is taxed the same way as regular income. All rent payments, security deposits, pet fees and any other payments you get for the use or occupation of your property count as rental income. That said, you can deduct many expenses related to a rental property, including mortgage interest, property tax, operating expenses, depreciation and repairs.
- Stock dividends: Dividends — money distributed to shareholders from a company’s earnings — are taxed depending on whether they’re classified as ordinary or qualified. Ordinary dividends are taxed the same way as ordinary income, while qualified dividends are taxed as capital gains.
- Savings account interest: You will owe taxes on most interest from an account that you can withdraw from in the year you receive that interest. This interest is taxed the same as earned income.
Passive vs. Active Income Tax
We’ve seen that in the vast majority of situations, passive income is taxed in much the same way as active income, but there can be some differences. After all, the taxes you owe will be determined not just by whether your income is passive or active, but your overall financial picture. You may find that working with a financial advisor can help you reduce your tax burden and maximize your passive income.
To get a sense of what your total income tax bill will be for the year, use SmartAsset’s free income tax calculator.
Passive Income Streams
It may be prudent to create multiple passive income streams rather than focusing on one. The principle of diversification applies here just as it would in building a stock portfolio: you can lower your risk and potentially increase your returns by spreading your investments among multiple areas.
As you start thinking about passive income and ways to earn it, try to create a varied portfolio with different asset classes, regions and sectors. Say you decide to purchase and rent out ten homes in Miami. You may be sitting pretty, doing minimal work and collecting thousands in rent each month. But if a hurricane comes through and levels all those homes, it’s going to take a lot of time and effort to get back to that position. That’s why it’s important to diversify.
Ways to Earn Passive Income
There’s no denying that passive income is a highly desirable way to build your net worth. Here are some great ways to develop a passive income stream yourself:
- Rental properties: Buying a home, condo or apartment complex and renting it out is one way to generate passive income. Of all the passive income options, this one might require the most work as landlords often need to take on multiple responsibilities to ensure their property remains in good condition and their tenants remain happy.
- REITs: If you want to get into real estate without doing the actual work of being a landlord, a real estate investment trust (REIT) is an excellent option. REITs own or manage real estate and allow you to invest in the business — and they’re known for their high-yield dividends.
- Dividend stocks: Dividend stocks distribute a portion of the company’s earnings to the shareholders on a regular basis and can be an excellent source of passive income.
- Bond ladders: A bond ladder is a portfolio where each bond comes to maturity at a different time at a steady pace. This is a low-risk way to generate steady income.
- High-yield CDs: In the current high-interest-rate environment, high-yield CDs are a particularly appealing option. With this option, you hand over your money for a set amount of time — often 12 months or more — and are paid a set interest rate over the life of the CD.
- High-yield savings accounts: These also benefit from the current rising rate environment and are an excellent option for passive income, though you will usually need to maintain a high balance to earn the top interest rate.
How to Grow Passive Income & Pay Little-to-No Tax Forever
Here are some tips for generating passive income while keeping taxes low:
- Focus on investments that will be taxed as long-term capital gains. Capital gains are the profits you make selling an investment. Say you bought a stock for $5 and two years later sold it for $10—the $5 in profit is known as capital gains. If you sold the stock within a year of buying it, it would be taxed as regular income. If you held it for more than a year, though, it is considered a long-term capital gain and is taxed at either 0%, 15% or 20% depending on your taxable income.
- Municipal bonds are not taxed by the federal government and those issued within your state may not be taxed by the state or municipality as well. These bonds are a safe bet and a great way to earn interest, save on taxes and help your government fund public projects and services.
- A Roth IRA isn’t the sexiest investment option, but they grow tax-free and you won’t owe taxes on withdrawals as long as you’re 59 ½ or older and have had the account for at least five years. This is a good way to establish passive income when you’re retired.
The Bottom Line
While earning money without working for it may sound like a pipe dream, it’s more accessible than you think. If you have savings, put them to work generating passive income for you—just understand the tax implications before you do so.
- A financial advisor can help you build a robust stream of passive income. Finding a qualified 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 interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Whether you’re considering getting started with investing or you’re already a seasoned investor, an investment calculator can help you figure out how to meet your goals. To see how much your investments will grow over time with a fixed rate of return, use our investment return and growth calculator.
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