Passive income is a type of income that does not require active involvement or participation by the taxpayer. It can include income from property rentals, royalties, dividends, interest, capital gains and more. However, passive income is not tax-free. Depending on the source and duration of the income, you may be subject to different tax rates and rules.
What is the passive income tax rate in 2024?
The passive income tax rate depends on the type and duration of the income. Generally, there are two categories of passive income: ordinary and capital gains.
Ordinary passive income is income that is taxed at the same rate as your normal income, such as interest, dividends, royalties and rental income. The tax rate for ordinary passive income ranges from 10% to 37%, depending on your taxable income and filing status.
Capital gains it’s the gain from the sale of an asset you’ve held for more than a year, such as stocks, bonds, real estate or collectibles. The tax rate on long-term capital gains ranges from 0% to 20%, depending on your taxable income and deposit status.
However, if you sell an asset you’ve held for less than a year, you’ll pay short-term capital gains tax, which is the same as your ordinary income tax rate.
In addition to federal tax rates, you may also have to pay state and local taxes on your passive income, depending on where you live and where the income comes from. State and local tax rates vary widely across the US, so you should consult a tax professional or use a tax calculator to calculate your total tax liability.
Is passive income taxed at a higher rate in the US?
Not necessarily. Passive income can be taxed at a lower or higher rate than your active income, depending on the type and duration of the income.
For example, if you earn interest from a bank account or dividends from a stock, you’ll pay ordinary income tax on that income, which could be higher than your effective income tax rate if you’re in a high tax bracket.
However, if you sell an asset you’ve held for more than a year and make a long-term capital gain, you’ll pay a lower tax rate than your effective income tax rate, unless you’re in the top 37% tax bracket.
3.8% Tax on net investment income
There is also a special tax called the Net Investment Income Tax (NIIT) This applies to certain high-income taxpayers who have net investment income above a threshold. NIIT is an additional tax of 3.8% on the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds the threshold amount.
The threshold amount for 2023 is $200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately.
Net investment income includes interest, dividends, capital gains, rental income, royalty income and other sources of passive income. However, it does not include wages, salaries, pensions, Social Security benefits, or IRA distributions.
How much tax do you pay on passive income?
The amount of tax you pay on passive income depends on several factors, including:
- The type and duration of the income
- Your taxable income and filing status
- Your state and local tax rates
- Your Deductions and Credits
- Your other sources of income
To calculate how much tax you pay on passive income, you need to:
- Determine the type and duration of your passive income
- Find out the applicable federal tax rate for this type of income
- Add any state and local taxes that apply to this type of income
- Subtract any deductions and credits that apply to that type of income
- Multiply the net amount by the total tax rate
For example, let’s say you’re single and have taxable income of $100,000 in 2023. You also have $10,000 in interest income from a bank account and $20,000 in long-term capital gains from the sale of some stocks.
To calculate how much tax you pay on your passive income:
- Interest income is ordinary passive income that is taxed at your regular income tax rate. Your federal tax rate on ordinary income in 2023 is 24%. Your state and local taxes may vary depending on where you live.
- Long-term capital gains are taxed at a lower rate than ordinary income. Your federal tax rate on long-term capital gains in 2023 is 15%. Your state and local taxes may vary depending on where you live and where your income comes from.
- You may have deductions and credits that reduce your taxable income, such as the standard deduction, personal exemption, or foreign tax credit. For simplicity, let’s assume you have no discounts or credits for this example.
- To calculate your net passive income, you add your interest income and long-term capital gains: $10,000 + $20,000 = $30,000
- To calculate your total tax rate, you add the federal tax rate and the state and local tax rate. For simplicity, let’s assume your state and local tax is 5% on both types of income. Your total tax rate on interest income is 24% + 5% = 29%. Your total tax rate on long-term capital gains is 15% + 5% = 20%.
- To calculate your tax liability, you multiply your net passive income by your total tax rate. Your tax liability on the interest income is $10,000 x 29% = $2,900. Your long-term capital gains tax liability is $20,000 x 20% = $4,000. Your total tax liability for passive income is $2,900 + $4,000 = $6,900.
How to Reduce Your Passive Income Tax Liability?
There are several strategies that can help you reduce your passive income tax liability, including:
- Holding assets for more than a year to qualify for the lower long-term capital gains tax rate
- Investing in tax-free or tax-deferred accounts, such as a Roth IRA, 401(k) or municipal bonds
- Harvest losses to offset gains or deduct up to $3,000 of net losses from your ordinary income
- Taking advantage of tax breaks for certain types of passive income, such as the qualified dividend rate, the special business income deduction or real estate professional status
- Diversify your sources of income to avoid NIIT or reduce your marginal tax rate
- Plan your income and expenses to optimize your tax framework and deductions
- Seek professional advice from a CPA or tax professional
Passive income can be a great way to build wealth and achieve financial freedom. However, it is not without tax implications. By understanding how passive income is taxed and how to reduce your tax liability, you can make smarter decisions about your passive income investments and maximize your after-tax returns.
