A long-time reader recently reached out with an intriguing idea; he wanted to share his passive income tax rate as compared to the high tax rate on his ordinary income.

I’ve written a lot about taxes, and I frequently discuss passive income ( although not as much as Passive Income MD). What I haven’t done is write about the tax rate on my own passive income streams.

Perhaps that’s something I’ll do in the future, but for now, I’ve got a detailed breakdown of one reader’s taxes paid in 2019 on a few different passive income streams. As the delayed tax day approaches, it’s a great time to take a look. Side note: you have less than a week left to make your 2019 IRA contribution as part of the backdoor Roth!

Do you know the difference between how your earned income and unearned income are taxed? The results below are quite revealing. When it comes to reducing taxes, passive income is king.

How Low is Your Passive Income Tax Rate? The Taxes on Passive Income Streams

I’m a longtime reader and listener of the blogs and podcasts in the White Coat Investor network, including this one. Applying basic financial principles has allowed me to save and invest early in my career. After maxing out tax-advantaged accounts and paying off student loans, I started a brokerage account at Vanguard with additional savings.

Then, I got into real estate investing. It is a great feeling to see your net worth begin to compound. I’ve been able to decrease my FTE at work and mitigate burnout, especially thanks to taxable investments that generate passive income.

In a classic post from 2017, WCI outlined six reasons why passive income beats active income. Half of those reasons were tax advantages. Today, I’d like to dive into the nitty-gritty of passive investment taxation, using my taxable portfolio (basically, a four-fund portfolio of cash/bonds, domestic stock, international stock, and real estate) as a case study from the year 2019. We’ve been drawing five-figures of passive income annually, and the benefits at tax time are manifest.

Ally Savings Account

A high-yield savings account is the most common and safest source of passive income, but at low interest rates and high tax rates–same as ordinary income, plus Net Investment Income Tax (aka Medicare surtax) due to being above the AGI cutoff. Our savings account houses our emergency fund, and also provides a safe harbor for upcoming quarterly tax payments and future investments.

We made $893 in 2019, with rates >1%, per Form 1099-INT. Using our total marginal rate (federal + state) of 40% plus 3.8% NIIT, we paid $391–nearly half of the interest income–in taxes! However, no social security taxes are due. Depending on how you conceptualize your annual income (first-in vs. last-in), I could instead use our total effective tax rate, which is 25%, and thus lessen the blow.

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Vanguard Brokerage Account

• VWIUX (intermediate-term municipal bond fund)

Dividend rates >2.5%, but muni bonds are subject to state tax only. Let’s use the marginal state rate (7.65%) less the 30% deduction for capital gains that my state allows. $1394 x .054 = $75 tax due. Can you say beer money?

• VTI (total stock market ETF, plus TLH partners)

These churned out qualified dividends >2% that are taxed at the lower long-term capital gains rate of 20% for my tax bracket, and are reported on Form 1099-DIV. Also need to add state and NIIT. $922 x (0.2+.054+.038) = $269 tax bill.

• VXUS (total international stock ETF, plus TLH partners)

These pump out both qualified and nonqualified dividends, but mostly qualified, and also at rates >2%. If I were a hardcore Boglehead, I would tease out that ratio, but guess what? The foreign tax credit basically nullifies the nonqualified dividends! $5164 x (0.2+.054+.038) = $1508 – $408 FTC = $1100.

The FTC is variable based on one’s percentages of foreign income and taxable income, and reported on Form 1116. While foreign countries withhold taxes pre-dividend, there is still an element of arbitrage in that the return credit only applies in taxable accounts, not tax-deferred accounts that can also hold international equities.

But hold the phone, have I done any tax-loss harvesting? Yes! We had about $10K of capital losses in the books and carried forward (reported on Schedule D), so I can use $3K of that against ordinary income.

However, because it came from holding taxable ETFs in the first place, I would argue that taxable dividends should be nullified in theory by this benefit (which is what some retired investors use if taxable is the largest account from which to draw… aka the “TLH ladder”).

MLG Capital Private Fund III

See Passive Income MD’s post on this fund for more information, but basically it’s a large, diversified private equity commercial real estate fund for accredited investors. The 8% preferred return alone brought in nearly $6000 last tax year.

MLG was able to pass on significant passive losses from depreciation to investors that year, so the tax bill was zero! True, there will be depreciation recapture due at some point in the future, but I’m looking at just one year in cross-section. Deferring taxes also gives you a leg up on the “time value of money”.

Without associated losses, passive income is subject to income tax, but no payroll or self-employment tax. Passive losses can offset passive income and such losses can be carried forward to future years. Details on Schedule E and Form 8582.

Remember that TLH is classified as a “capital” loss, and real estate depreciation a “passive” loss for tax purposes–the two cannot commingle. Also, my state has a $500 limit on passive losses to offset passive gains, while the fed does not. I did not meet that limit via the fund this year from properties in my home state.

Adding it all up

The cumulative tax bill above is $1,835 on $14,373 of gross annual passive income, yielding a blended passive income tax rate of ~13% on my personal lineup of passive investments. Gee, that sure beats the 40% tax treatment on an extra work shift in December. If you give the ETFs a pass for being tax-loss harvesting workhorses (ceiling of $3K benefit annually), that brings the tax rate on my passive income down to ~8%. Using effective rates in lieu of marginal rates could bring it down even further.

The bottom line is that my taxable investments received 3x-5x less taxation than additional 1099 work, in the context of my personal tax situation that year. While “taxable investments” sound onerous, they sure beat additional earned income. However, I must point out that it is hard work that generates investable income in the first place!

I use PoF’s portfolio spreadsheet to allocate the taxable assets among my tax-sheltered accounts. I’m not a CFP or CPA (nor do I have a financial relationship with Ally, Vanguard or MLG), but understanding the details of your investments and tax circumstances can create “wealth synergy” that might not be possible when working with one professional or another in isolation. William Bernstein’s Investor’s Manifesto and Mike Piper’s Taxes Made Simple were instrumental in establishing my knowledge base.

Conclusion

Building a portfolio of passive investments and putting your money to work is the best side gig out there, especially in terms of tax treatment. While taxable investments are often compared to tax-deferred or tax-free investing vehicles in the same breath, comparing them to additional actively earned income paints a much different picture.

Hopefully, I have convinced you to convert as much of your active income to passive income, and above all, not someone else’s passive income stream (whole life insurance, AUM fees, etc)….

I track my gross passive income as a percentage of taxable income and my goal is to achieve 25%. Currently, I’m at 4%. What’s your passive income goal?

Have you calculated your passive income tax rate? What tax-efficient investments are delivering passive income for you?