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.
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Get Started NowPassive vs. Non-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.
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.
Types of Passive Income
Passive income streams can provide earnings with minimal ongoing effort, making them a popular choice for building financial security. Here are some common types of passive income:
- Rental income: Earnings from leasing out property, such as homes, apartments or commercial spaces. It requires an upfront investment but can generate consistent cash flow.
- Dividend income: Regular payments from owning stocks in dividend-paying companies. This income depends on the company’s performance and dividend policies.
- Royalties: Payments received for intellectual property like books, music or patents. Royalties provide ongoing income as long as the asset remains in demand.
- Peer-to-peer lending: Interest earned by lending money through online platforms. Returns vary based on the loan’s risk level.
- Online content revenue: Income from ads, affiliate links or subscriptions tied to blogs, YouTube channels or other digital platforms.
Types of Non-Passive Income
Non-passive income requires active involvement, often involving consistent effort to maintain and grow. Here are common types of non-passive income:
- Salaries and wages: Compensation for full-time or part-time work, typically earned through employment contracts or hourly work arrangements.
- Freelance or gig work: Earnings from short-term or project-based jobs, such as writing, graphic design or ridesharing services. This type of income often depends on the worker’s time and skills.
- Business profits: Income from actively managing or running a business, such as retail shops, restaurants or service providers. Success often hinges on the owner’s involvement.
- Consulting fees: Payments for providing expert advice or services in a specific field, often tied directly to the consultant’s time and expertise.
- Sales commissions: Income earned based on selling products or services, commonly seen in industries like real estate or insurance.
Tax Treatment of Passive and Non-Passive Income
Non-passive income, like wages, freelance earnings, or business profits, is taxed as ordinary income at progressive tax rates based on an individual’s total earnings. These rates range from 10% to 37%.
Active income is also subject to payroll taxes, such as Social Security and Medicare, further increasing the tax burden. For self-employed individuals, these taxes are paid as self-employment tax, encompassing both employer and employee portions.
However, 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.
Passive income, such as long-term capital gains or dividends, is often taxed at a lower rate than earned income, depending on the type of investment. For example, qualified dividends may benefit from capital gains tax rates, which are lower than ordinary income tax rates. Rental income, on the other hand, is taxed as ordinary income, but the IRS provides a number of deductions that landlords can use to lower their taxable income from rentals.
However, passive income may also be subject to the Net Investment Income Tax (NIIT), an additional 3.8% tax for high earners. The IRS also applies passive activity loss rules, which prevent taxpayers from using losses from passive activities to offset non-passive income.
Net Investment Income Tax and How to Avoid it
The Net Investment Income Tax (NIIT) is a 3.8% tax on certain investment income for high-income individuals, estate and trusts. It primarily applies to passive income, such as rental earnings, dividends, interest and capital gains, rather than non-passive income like wages or business profits. However, some income from businesses classified as passive activities can also trigger the NIIT.
Introduced as part of the Affordable Care Act, this additional tax applies to taxpayers with modified adjusted gross incomes (MAGI) above the following thresholds:
Net Investment Income Tax (NIIT) Thresholds in 2025
| Tax Filing Status | MAGI Limits |
|---|---|
| Single or head of household | $200,000 |
| Married filing jointly | $250,000 |
| Married filing separately | $125,000 |
| Qualifying widow(er) with dependent | $250,000 |
| Estates and trusts | $15,650 |
To minimize or avoid the NIIT, individuals can consider strategies such as investing in tax-exempt municipal bonds, contributing to tax-advantaged accounts like IRAs or 401(k)s, and strategically timing the sale of investments to spread gains across multiple tax years.
Additionally, reclassifying passive activities as active through material participation may help certain business owners avoid the NIIT on related income. Consulting with a tax professional is advisable to ensure compliance while optimizing tax strategies tailored to individual circumstances.
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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