Passive income is a type of income that does not require active involvement or participation from the taxpayer. It can include income from rental properties, royalties, dividends, interest, capital gains, and more. However, passive income is not tax-free. Depending on the source and duration of the income, it may be subject to different tax rates and rules.
What is the passive income tax rate in 2023?
The passive income tax rate in 2023 depends on the type and term 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 regular 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 are profits from selling an asset that you held for more than a year, such as stocks, bonds, real estate, or collectibles. The tax rate for long-term capital gains ranges from 0% to 20%, depending on your taxable income and filing status.
However, if you sell an asset that you held for less than a year, you will pay short-term capital gains tax, which is the same as your ordinary income tax rate.
In addition to the 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 is sourced. The state and local tax rates vary widely across the U.S., so you should consult a tax professional or use a tax calculator to estimate your total tax liability.
Is passive income taxed at a higher rate in the U.S.?
Not necessarily. Passive income can be taxed at a lower or higher rate than your active income, depending on the type and term of the income.
For example, if you earn interest from a bank account or dividends from a stock, you will pay ordinary income tax on that income, which could be higher than your active income tax rate if you are in a high tax bracket.
However, if you sell an asset that you held for more than a year and realize a long-term capital gain, you will pay a lower tax rate than your active income tax rate, unless you are in the highest tax bracket of 37%.
3.8% Net investment income tax
There is also a special tax called the Net Investment Income Tax (NIIT) that applies to certain high-income taxpayers who have net investment income above a threshold amount. The NIIT is an additional 3.8% tax 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 filers, and $125,000 for married filing separately filers.
Net investment income includes interest, dividends, capital gains, rental income, royalty income, and other passive income sources. 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, such as:
- The type and term 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 term of your passive income
- Find out the applicable federal tax rate for that type of income
- Add any state and local taxes that apply to that 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, suppose you are single and have a taxable income of $100,000 in 2023. You also have $10,000 of interest income from a bank account and $20,000 of long-term capital gains from selling some stocks.
To calculate how much tax you pay on your passive income:
- Interest income is ordinary passive income taxed at your regular income tax rate. Your federal tax rate for 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 for long-term capital gains in 2023 is 15%. Your state and local taxes may vary depending on where you live and where the income is sourced.
- You may have deductions and credits that reduce your taxable income, such as the standard deduction, the personal exemption, or the foreign tax credit. For simplicity, let's assume you have no deductions or credits for this example.
- To calculate your net passive income, you add your interest income and your long-term capital gains: $10,000 + $20,000 = $30,000
- To calculate your total tax rate, you add your federal tax rate and your state and local tax rate. For simplicity, let's assume your state and local tax rate is 5% for both types of income. Your total tax rate for interest income is 24% + 5% = 29%. Your total tax rate for 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 for interest income is $10,000 x 29% = $2,900. Your tax liability for long-term capital gains 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 tax liability on passive income?
There are several strategies that can help you reduce your tax liability on passive income, such as:
- Holding assets for more than a year to qualify for the lower long-term capital gains tax rate
- Investing in tax-exempt or tax-deferred accounts, such as Roth IRAs, 401(k)s, or municipal bonds
- Harvesting losses to offset gains or deduct up to $3,000 of net losses from your ordinary income
- Taking advantage of tax breaks for specific types of passive income, such as the qualified dividend rate, the qualified business income deduction, or the real estate professional status
- Diversifying your sources of income to avoid the NIIT or lower your marginal tax rate
- Planning your income and expenses to optimize your tax bracket and deductions
- Seeking professional advice from a CPA or a tax planner
Passive income can be a great way to generate wealth and achieve financial freedom. However, it is not without its 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.