As we mentioned before, one of the biggest differences between active and passive income is how tax is calculated. When you have an activity that makes money, like owning a restaurant, you have to report your profits from this business on your taxes.
You also have to calculate your expenses separately and add them up to determine whether or not you made a profit. If you spent more than you earned, then you lost!
With passive income, however, these calculations are done for you in most cases. Because it is dependent on something external (like the amount of revenue another person earns), someone else’s actions will handle part of the work for you in terms of keeping track of what you earn and why you earn it.
This other person can be anyone, including yourself two years down the road. It could be a friend who shares their paid-off house with you, or a colleague who publishes a book that sells well.
Whatever it is, it doesn’t matter as long as they get enough money per year to qualify as a source of income for the purposes of taxation. This way, you don’t need to worry about figuring out if you broke even after paying bills, because no one else does. You only care about you!
Taxes are complicated, but hopefully this article helped clear some things up. Now you know how different types of passive income affect your personal finances and how to deal with those effects when they arise.
One of the biggest differences in how people tax passive income is capital gains or capital losses. When you make money through investments, you typically earn either a dividend or profit (income from the investment).
But not all dividends are considered taxable income. Some companies don’t report their earnings publicly, so they’ll pay no income tax on them. Likewise, some investors only recognize profits when they sell an asset.
That means some years there will be no income reported, and thus no income tax due. For example, if you own a house that you live in but also rent out to make extra money, you may not realize it as “profit” income until your taxes for the year are completed!
However, when you do eventually sell this property, any capital gain can add to your net worth and reduce debt, which makes it a good thing. And because these types of assets aren’t taxed like other income, buying such items earlier is one way to save on taxes.
As we mentioned before, one of the main differences between active and passive income is how each form of revenue is taxed. Active income includes the cost of goods you are buying or producing yourself (such as by writing this article) and therefore all that money is taxable.
With passive income, none of the earnings go towards financing additional purchases so there is no direct link to what you pay for things. This means those incomes are not subject to taxation.
The tax difference comes in when your financial institution calculates your annual gross income. Because there’s no longer an activity linked to the income, they will subtract any amounts received from investments and other sources and add back in any expenses paid with that income!
This is why it’s important to know which types of income are considered investment-grade spending. For example, if you spend the monthly budget payment on food, shelter, and transportation, then that’s not necessarily classified as an investment because those items aren’t expensive per se. If however, you invest the rest of the money in education or health services that can be quite costly, then it becomes more like owning a car or house and thus investing was the better choice.
An additional way to reduce your tax bill is by applying for deductions and exemptions for certain types of income or expenses. One of these is called an “excess capital loss” (or, more commonly, a “net operating loss”).
You can apply this if you have an excess loss in another area of taxation. For example, if you had a net profit from business use of $2,000 then your taxable income would be higher than that at around $20,000. You could apply to have a net operating loss of up to $10,000 so your tax bill will be lower.
This is because net operating losses are carried forward to future years. So instead of having to pay taxes on all your earnings today, you only have to do it when you make money in the future.
Your carry-forward amount is determined by how much debt you have as well as how much equity in your house. The greater the balance between those two, the longer you can keep your NET losses.
However, there is a limit to how many past losses you can deduct before they start to negatively affect your tax position. This depends on what year you are in as well as your personal situation.
There is one more major difference between active and passive income that some people get confused about — what are called “excess capital gain distributions.” This happens when an individual distributes all of their own stock, or part of their shareholdings in either a retirement account or other investment vehicle.
The person can choose to have these distributed as a dividend, which means they receive the earnings from the company that owns the shares for the life of the distribution (usually at least 1 year). Or, they can choose to sell the whole lot and pay tax on any profit made after deductions for costs like brokerage fees and possible allowances.
This is where things can get confusing. Because individuals cannot avoid paying taxes by choosing to do this, many people believe that it is not necessary to generate additional income through investments. But this isn't quite true.
By avoiding investing money, you are denying yourself potential wealth. It's like saying you will never be rich because you don't want to spend money buying expensive clothes or taking nice vacations. Even though most people who are wealthy didn't start out spending heavily, it is important to recognize that spending money doesn't make someone richer.
Generating additional income through savings, invested assets and sharing services provided on mobile phones and laptops helps reduce stress and allow you to focus on other areas of your life. These opportunities exist for anyone, even if you don't agree with how much taxation is applied to income.
Miscellaneous income is any kind of earnings that are not taxable as salary or dividend income. This includes things like interest, royalties, pensions, gift cards, and more. Some examples of miscellaneous income include:
Dividend income (income from stocks)
Royalties (money paid to you for your creative work)
Interest (paying money for access to bank accounts)
Pension benefits (payments for life after employment)
Gift card rewards (for purchases you make using their card)!
Of these, only dividends and pension benefits are considered passive income. Dividends usually require you to hold a certain amount of stock in order to receive the income, but not with respect to tax. As long as you stay within IRS guidelines for what constitutes “enjoyment” of a company’s shares, you will be okay.
With regards to pensions, while it may seem difficult to achieve at first, most employers offer simple strategies to maximize yours. For example, investing an appropriate monthly contribution into your 401k can easily be done via automatic deduction.
By having this done automatically, you have eliminated the need to actively manage your savings. Also, remember that taxes are due upon IRA withdrawal, so being able to do it without too much effort really helps!
Another way to gain additional retirement income is through personal investments.
As mentioned before, you can run your business as either an employee or owner. But what is the difference? Well, as an employee, you are typically paid wages, which usually have income tax withheld for both federal and state taxes.
As an owner, however, you don’t receive a salary, instead profits and losses from the business are distributed to you (the owner) according to how much money you made while it was in operation. These distributions are called “passive income” because you didn’t do anything to generate them, but you did contribute to the success of the business by investing time in it.
This distribution, though, isn’t like other types of passive incomes that we discussed earlier. Because this type of income comes directly from the business, not you personally, it is considered a “business expense” for calculating taxable income.
As we discussed, capital gains are when you sell an asset (like a car or house) at a higher price than what you paid for it. With stock investing, however, this is not the case.
When you invest in shares of a company, the cost per share is typically lower than the market price of the stock. Therefore, even if the stock goes up dramatically, your net income is the difference between the two prices!
This is why some people call it “net loss” investing. It is very possible to make lots of money through equity investment, but only by selling your shares later at a lower price.
As with any form of investing, there are tax implications depending on how you earn your income. These vary quite a bit depending on whether your income comes directly or indirectly from your investments.
The most common way to avoid paying high taxes on dividends and capital gain distributions is to consider them as ordinary income. This means they will be taxed like normal income, potentially up to 40% in the UK.
Income derived from bond investments is typically considered passive income because you are not actively doing anything to generate it. You are simply investing in securities that provide guaranteed returns, and your portfolio will grow with time!
Bonds are also very tax-efficient forms of investment. Because they are debt instruments, there are no current or capital gains taxes when you sell them. Only ordinary income tax applies.
However, before you consider buying individual bonds, do some research and understand how bond taxation works. For example, what kind of dividends Bond investors get taxed at different rates depends on their personal situation.
Furthermore, although capital gain taxes apply when you buy and later sell a bond, you may be able to exclude part of the cost of the bond as well as any accrued interest when calculating your taxable income.
So while earning money through bonds can be more tax efficient than other types of investment, careful tax planning is still needed.