There are many ways to generate passive income, but regrettably, most of them are taxed.
This is especially true for income-producing investments, as just a small number of them let you avoid paying taxes.
Even though they are normally paid annually or all at once, there are various credits, settlements, and payouts that you might earn without paying taxes. Here are a few examples of non-taxable passive income streams.
Tax-Free Municipal Bonds
Purchasing municipal bonds is the simplest—and in fact, one of the only—ways to make money from your assets tax-free.
Municipal bonds are typically tax-exempt at the federal level. State-level tax breaks are frequently available to citizens of the issuer’s home state as well.
However, any eligible capital gains are wholly taxable.
No matter how much an inheritance is, you won’t have to worry about paying federal tax on it.
Estate taxes may occasionally need to be paid by the deceased, although beneficiaries are not concerned about it. You must confirm whether all of your proceeds are entirely tax-free because six states do tax beneficiaries who receive inheritances.
Life Insurance Proceeds
Your life insurance policy’s proceeds will be distributed to you tax-free if you are the designated beneficiary.
Even if you acquire sizable insurance, say one for $1 million or more, this is still the case.
It should be noted that you will probably have to pay tax on some or all of the proceeds of a life insurance policy if you cash them in rather than collecting the proceeds of a death benefit.
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Disability payments may occasionally be regarded as taxable income.
However, any disability benefits you receive are not regarded as taxable income if you pay all of the premiums for a health or accident insurance plan.
If gifts exceed the yearly gift tax exclusion amount, which is $17,000 per person for 2023, the giver may occasionally be required to pay taxes on the excess amount.
Gift receivers, however, are never required to pay taxes on what they get.
Before 2019, alimony was tax deductible for the payer and taxable for the recipient. After that year’s January 1st, neither the payers nor the recipients of alimony could claim a tax deduction for such payments.
But keep in mind that some states, including California, do not follow this federal reform and continue to tax alimony.
Child support payments are neither deductible by the payer nor taxable by the receiver, according to the IRS, exactly like alimony payments.
Withdrawal from a Roth IRA
In contrast to standard IRAs, Roth IRA payouts are frequently tax-free.
As long as your withdrawals are “qualified” — that is, if you have had the account open for at least five years and are older than 59.5 — you won’t be required to pay tax on any money you withdraw, regardless of whether it was earned from interest or capital gains.
Payments for Disaster Mitigation
Your state or local government might provide you with a disaster mitigation payment if you experience a disaster.
This compensation is not regarded as taxable income.
Adoption Reimbursements That Qualify
You can exclude from income employer-provided adoption assistance payments in addition to receiving a tax credit for eligible adoption expenses.
HSA Funding Distribution that is Qualified
You are permitted to move money from your IRA to an HSA account once without paying taxes on the transfer.
Earnings from a State Without Income Taxes
Currently, Alaska, South Dakota, Nevada, Florida, Texas, Wyoming, Washington, and Tennessee are the eight states that do not tax income that is typically subject to federal taxation.
This is one of the few instances where ordinary taxable income is exempt from tax.
Even if you reside in a state where there is no income tax, you will still be required to pay federal taxes on your income.
How to Reduce Passive Income Taxes
Even if you have taxable income, there are things you may do to lower your tax obligation.
The following are some of the top options:
Utilize tax-deferred accounts
Your assets will grow tax-free if you keep them in tax-deferred accounts like IRAs and 401(k) plans.
Hold for the Long Run
Holding investments for a long time enables you to benefit from lower long-term capital gains tax rates as well as avoid multiple taxable transfers.
Harvest Tax Losses
You can take unrealized losses from your portfolio and utilize them to reduce any taxable profits you might have made over the year.
You can use up to $3,000 annually to offset your ordinary income if your losses outweigh your gains.