Passive income streams can take many different forms. The usual ones that come to mind involve real estate rental and interest income.
Other types might not be as well known, such as peer-to-peer lending, information products, and royalties. Whatever avenue you take to collect passive income, you will hopefully have the problem of choosing how to spend these funds.
If you have the financial stability to do so, investing passive income rather than spending it outright can be beneficial. Not only can you create additional revenue streams, but you can also offset taxes.
So rather than burning your passive income on something frivolous, consider the following options:
- Reinvest in real estate to offset taxes.
- Max out your HSA.
- Use retirement plans to your advantage.
Reinvest in Your Real Estate to Offset Tax Implications
In a year with substantial passive income related to a rental property, you can offset taxes by investing back in the property. This can include undertaking major repairs or renovations to the rental property. These expenditures can either be expensed out against your tax liability or added to your basis, depending on scope.
Basis is important if you ever decide to sell the property at a gain. The more basis in the property you can prove, the less capital gains you will have to pay tax on.
Some common examples of improvements that increase basis include new utility installation and construction of additions. Another example would be increasing the total area by purchasing land adjacent to the existing real estate and combining properties.
Max Out Your HSA
If you are able to make contributions to a health savings account (HSA), this is a fantastic way to invest.
HSAs are usually thought of as a simple but effective way to get a tax deduction on healthcare expenses. However, they can also be one of the smartest investment options in existence.
Why is it so amazing, do you ask? The reason boils down to taxation and the fact that you can invest your contributions into mutual funds. Unlike a flex health spending plan with “use it or lose it” rules, contributions roll over from year to year.
This means as of 2022 you can put in $3,650 for yourself or $7,300 for a family total. Doing this every year and letting your funds grow can really add up over time.
With other types of contributions, you’re going to pay taxes either when you put the money in or withdraw it. HSAs, on the other hand, manage to get around the old “death and taxes” certainty. You are able to get a tax deduction for any contributions, much like a traditional 401(k). Unlike a traditional 401(k), you don’t have to pay tax upon distribution as long as you are reimbursing health expenses.
But will I really use all that money to pay for medical costs? It’s estimated that a 65-year-old couple might need $300,000 to cover medical costs in retirement. Therefore, you are likely to have plenty of expenses to reimburse yourself with. Any out-of-pocket medical expenses essentially serve as a loan to yourself. Just make sure to keep track of all your receipts for future reimbursement.
Use Retirement Plans to Your Advantage
Taking your passive income and putting it into a SEP IRA or a traditional 401(k) has beneficial tax implications. Contributions you make to these plans are tax deductible and can take the bite out of your overall tax liability.
If you don’t have access to an employer-sponsored 401(k), you can still contribute by creating a solo 401(k). In order to take advantage of this investment technique, you will need to apply for a federal EIN number.
If you have plenty of funds to spare, you’re in luck. Contribution limits for both SEP IRAs and solo 401(k)s have increased in 2022 up to $61,000. Note: Contribution limits are calculated based on your earned income, not passive income. Therefore, you cannot contribute to a SEP IRA or solo 401(k) if you do not have any earned income.
If you’re in the real estate game, solo 401(k)s can be a savvy way to increase passive income tax savings. It is fairly well known that properties can be purchased by retirement accounts such as IRAs. A drawback is that income generated is subject to UBIT (unrelated business income tax) if non-recourse loans have been obtained for the purchase. Purchasing real estate under a solo 401(k), however, exempts the buyer from needing to pay the UBIT. Since UBIT can be up to a maximum of 37%, tax savings can be huge.
With this tax strategy, certain stipulations do apply concerning such things as loan classification. It is highly recommended to speak with an investment advisor before creating or investing with a solo 401(k).
Some individuals consider passive income to be “living the dream.” Theoretically the income rolls in automatically with very little time spent on your end directly conducting business.
Being smart with your passive income doesn’t end when the money hits your bank, though. By making good decisions with your passive income, you can set yourself up for tax savings or boosting future earnings.
On the date of publication, John Rampton did not have (either directly or indirectly) positions in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
John Rampton, the founder and CEO of Due, is an entrepreneur and connector. While recovering from a serious construction accident when he was 23, he studied how to make money work for you, not against you. He has since written many articles about finance, entrepreneurship and productivity.