Working hard for the money or letting the money work hard for you? That’s the main difference between active and passive income.
Active income typically comes in the form of your wages earned from working a job or running a business. Passive income includes sources you don’t actively work for, like rental income, investments, shareholder distributions or licensing fees.
While both types of income can support your lifestyle and meet your needs, each has their own set of tax consequences — which can significantly impact your bottom line.
The ins and outs of active income
When you receive a paycheck for your work, the income is considered active because it is directly tied to your efforts and time spent on the job. As a business owner, you may pay yourself a salary or wages from your company’s earnings, which would fall under the category of active income.
From a tax perspective, active income is subject to federal income tax, as well as payroll taxes such as Social Security and Medicare. And depending on your income level, you may also be liable for state income tax. The tax rates for active income are typically progressive, meaning that the more you earn, the higher your tax rate.
There are strategies to reduce the tax burden on your active income. As a businessowner, you may consider exploring the many tax deductions and credits available. Plus, expenses related to running a business — such as office supplies, equipment and professional services — may be deductible, reducing your overall taxable income.
Additionally, contributing to retirement accounts or health savings accounts can provide tax benefits for all employees, while saving for the future.
Simplifying the tax consequences of passive income
Passive income is generated from sources in which you’re not materially involved. These income streams can be a lucrative way to build wealth and diversify your income sources — as long as you’re staying on top of tax obligations.
Taxes will depend largely on the exact source of your passive income and your financial situation as a whole. Rental income, for example, is typically taxed at your marginal tax rate, but you may be able to deduct expenses related to managing the property — from maintenance and repairs to pet fees and property taxes.
Shareholder distributions from corporations are taxed at the individual level and may be subject to capital gains for qualifying investments held for more than a year. And regarding royalties and licensing fees, the tax treatment can vary depending on the nature of the income and the agreements you have in place.
It’s best to keep detailed records of all income received from passive sources and, as always, consult with a tax professional to ensure compliance with tax laws and regulations.
Optimizing your tax strategy
By carefully managing your income streams, you can minimize your tax liability and maximize your profitability. Remember, it’s critical to stay informed about changes in tax laws and seek guidance from a qualified tax advisor. Get in touch to see how Magone & Co can help.
This document is for informational purposes only and should not be considered tax or financial advice. Be sure to consult with a knowledgeable financial or legal advisor for guidance that is specific to your unique circumstances.