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6 Smart Ways to Reduce Taxes on Pass-Through Income

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SmartAsset: how is the transferred income taxed?

SmartAsset: how is the transferred income taxed?

When you own or invest in a business, you may receive distributions of its profits. Depending on the structure of the business, the business may not have paid taxes on these profits before distributing them to you. These companies are called flow-through entities. Here’s how passed-through income is taxed and what you need to know about it.

A financial advisor can guide you through different tax strategies to reduce your liability.

What is transmission income?

Pass-through income is the profits earned by a business that are distributed to owners and shareholders without the entity paying taxes. Income taxes are an integral part of doing business, but some types of entities “pass through” their income and avoid taxation. Although these business entities avoid taxes, whoever receives these distributions is responsible for paying taxes on these profits.

Which business entities have transfer income?

Not all businesses are eligible for transmission income. The most common types of businesses that have pass-through income include:

In many cases, these business entities are closely tied to a single business owner or a small group of investors. These entities pass through both the profits and losses that a business may incur each tax year.

Who pays the taxes on transferred income?

When a flow-through entity makes distributions to shareholders or partners, the beneficiaries are those who pay taxes on those profits. In most scenarios, these distributions qualify as ordinary income for tax purposes.

For example, if two siblings are equal partners in a business. Although the partnership must file a tax return, it is not required to pay taxes. Instead, each sibling is responsible for paying taxes on their share of the income.

How is the transmitted income taxed?

SmartAsset: how is the transferred income taxed?

SmartAsset: how is the transferred income taxed?

Passed-through income is taxed as ordinary income, which generally corresponds to the highest tax brackets paid by taxpayers. In 2022, ordinary income tax rates range from 10% to 37%. The tax rate that applies to your income depends on your filing status and your income.

High-income taxpayers may also be liable for a “net investment income tax” of 3.8% on unearned income. Depending on how you earned the income passed on, it could be subject to this additional tax burden. Plus, it might increase your adjusted gross income enough when other sources of income also have to pay those extra taxes.

How can pass-through income reduce taxes?

With the Tax Cuts and Jobs Act 2017, FTE business owners can benefit from a tax deduction of up to 20% on qualifying income. This tax deduction allows eligible business owners to deduct up to 20% of their qualified business income (QBI). In addition, they may also deduct 20% of qualifying REIT dividends and qualifying publicly traded partnership (PTP) income. QBI is also known as the Section 199A deduction.

Can you reduce taxes on passed on income?

Since the passed-through income is taxed as ordinary income, investors have a strong incentive to incorporate tax reduction strategies into their financial plan. If you need to reduce your taxable income, here are six common strategies to consider:

  • Create or contribute to a company pension plan. If you have a job that offers a company retirement plan like a 401(k), contribute as much as possible. For investors who own a business, consider setting up your own company pension plan.

  • Maximizing Individual Retirement Accounts (IRAs). Make the most of a traditional IRA for you and your spouse. Be aware of income limits for you or your spouse if either of you has access to a company retirement account at your workplace.

  • Health Savings Accounts (HSA). HSAs require a high-deductible medical insurance policy, so consider your medical needs first. These accounts offer a triple tax advantage – a tax deduction now, the money grows tax-free and can be withdrawn tax-free for eligible medical expenses.

  • Buy tax credits. Tax credits reduce your taxes dollar for dollar for the amount you invest.

  • Minimize taxable income on investments. Reduce your taxable income by placing income-producing investments in tax-advantaged accounts. For example, REITs and bonds have regular distributions that increase your taxable income. The best option is to hold these investments in a retirement account.

  • Realize losses on investments. If you have investments that are worth less than what you paid for, consider selling them to realize the losses to offset your income. You can offset an unlimited amount of capital gains and up to $3,000 of ordinary income each year.

Conclusion

SmartAsset: how is the transferred income taxed?

SmartAsset: how is the transferred income taxed?

Pass-through income avoids taxation at the business entity level. Instead, profits are distributed to business owners, shareholders, and partners as ordinary income. Ordinary income rates are generally the highest tax rates a taxpayer will pay, but there are ways to reduce your taxable income. Talk to your tax and financial advisor to find ways to reduce your taxes.

Tips to reduce your taxes

  • A financial advisor can help you optimize your financial plan to reduce your tax liability. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your matching advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.

  • To reduce your taxes, it is useful to anticipate what your tax obligations might be. SmartAsset’s Federal Income Tax Calculator estimates how much you owe in taxes based on your income, location, filing status, and deductions.

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