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Nov 17, 2020

November 17, 2020

How is Passive Income Taxed?

Maximising your diversified income with a smarter tax plan

If you pick the brain of anyone who has managed to accumulate significant wealth, they'll usually have one thing in common - multiple, lucrative sources of passive income. When you've found a successful strategy to put your money to work, long-term financial stability is all but guaranteed. However, part of any successful passive income strategy is minimizing tax expenses. Here's what you should know about how certain forms of passive income are taxed, and how to reduce your tax burden.

How is Passive Income Taxed?

Dividends

Investors who withdraw dividends have to pay taxes on them, but the amount owed depends on the kind of dividend.

There are two types of dividends, qualified and unqualified. Unqualified, also known as ordinary dividends, are taxed at your regular income bracket. If you're in the 22% tax bracket, your dividends will be in that same tax bracket.

Qualified dividends are taxed at the capital gains tax rate, which is much lower than the regular income tax rate. Talk to a financial planner or accountant about how to determine what kind of dividends you have, and whether you can change any of your unqualified dividends into qualified.

Real Estate

Landlords who collect rent from their tenants pay regular income tax rates on that income. Fortunately, landlords can deduct repairs, maintenance, depreciation and mortgage payments, significantly decreasing their taxable income.

tax deductible expenses on your rental property

Side Hustle or Freelance Income

Freelancers and independent contractors are responsible for paying taxes to the IRS, because clients don’t withhold money from freelance paychecks like a traditional employer would.

The total taxes paid as a freelancer will be higher than as a W-2 employee, because a freelancer is both the employer and employee. That’s why it’s crucial to deduct any relevant expenses.

How to Reduce Taxes on Passive Income

There are a number of legal ways to limit your tax burden. Here are the best strategies:

Track Expenses

The best way to minimize taxes on passive income is to claim as many eligible deductions as possible. If you don't already have a system for tracking deductions, you may be missing out on possible tax savings.

You can input expenses manually into a spreadsheet, use budgeting software like Mint or Tiller or pay for business software like Freshbooks or Wave, which will sync with your bank and credit card accounts. If you're new to tracking savings, use the official OnJuno Guide to Budgeting to get started.

Whichever system you choose, write down the amount, company name, item description and upload a picture of the receipt. This will also make it easier if you ever get audited and have to prove your deductions were eligible - a very real possibility for anyone embracing a more complicated tax strategy.

Earn Interest on your Tax Money

Instead of keeping your quarterly tax payments in the same checking or savings account that you use for everyday expenses, open a separate account.

Every month, go through your net earnings and transfer 20 to 30% into that separate account. When it's time to pay for quarterly taxes, you can use the money from that account.

If you want your money to earn interest before sending it to the government, open an OnJuno Checking Account, which has an interest rate between 1.15% and 2.15% depending on the account type.

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Deduct Related Expenses

The type of expenses you can deduct depends on the type of income you earn. For example, if you're a freelance web designer, you can deduct your monthly Adobe InDesign subscription. If you drive for Lyft, you can deduct the cost of gas.

You may also be able to deduct part of your mortgage or rent if you have a home office, as well as your internet and utility bills.

If you're unsure if a deduction qualifies, look through the IRS's list of qualified deductions. If you're using a software program to file your taxes, they may also have resources about eligible deductions.

Hire an Accountant

Hiring an accountant is more expensive than using tax software, but the right accountant can save you more money. They can help you find extra deductions or suggest tax-saving strategies, like switching to an S-corp.

Not all accountants have the same level or area of expertise, however. Just as choosing the right accountant can save you a significant amount of money come tax season, choosing the wrong one can end up being a colossal waste of time and money.

Try to find an accountant who focuses on the type of income you earn. Ask others in your niche if they have accountant recommendations.

"It's important to hire a proactive tax advisor who is passionate about working through complex problems, providing ongoing advice and being accessible whenever you have a question," said Ron Strobel, CFP® of Retire Sensibly LLC.

An accountant can also handle any audits that come up.

Pay Quarterly Taxes

Once you start earning a significant amount of passive income, you may have to pay quarterly state and federal taxes. Quarterly taxes are calculated based on your income and deductible expenses. Check the IRS website to see when quarterly payments are due.

If you don't pay quarterly estimated taxes, the government may issue a penalty when you file your taxes in April. They may also levy a fine if you underpay your quarterly taxes. If you have an accountant, they can recommend how much you should pay every quarter.

A basic rule of thumb is to add up that quarter’s income, subtract any relevant deductions and pay between 20 to 30% of that amount.

Change Withholding

If you still have a full-time job, you can change the tax withholding on your paycheck. Doing this will increase the amount that your employers remove from your paycheck.

This won’t decrease your tax burden per se, but adequately increasing your withholding will absolve you from owing any estimated quarterly taxes. In this situation, your employer is doing the tax paperwork you would otherwise be obliged to do.

Ask your payroll department if you can fill out a new W-4. Make sure to do this for both federal and state taxes if your state charges income tax. While this isn't as specific as paying quarterly taxes, it does automate the tax-paying process.


Zina Kumok
Zina Kumok has written for outlets such as Investopedia, Credit Karma, and Learnvest. Her expertise has been featured in Glamour, BBC, and Nerdwallet.

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