Passive Income in Retirement: Which Types Are Taxed and Which Are Not

Why Not All Passive Income Is Taxed the Same

The IRS treats different types of investment income in fundamentally different ways. The same $10,000 in annual income can be taxed at 0%, 15%, 20%, 23.8%, or as high as 37% depending on where it comes from. Planning your retirement income mix around these differences - rather than focusing purely on total return - is one of the highest-leverage tax strategies available. Qualified dividends are taxed at long-term capital gains rates: 0%, 15%, or 20% depending on your total taxable income. In 2026, a married couple with taxable income up to approximately $96,700 pays 0% on qualified dividends. This is one of the most tax-efficient income sources available to retirees. Dividends from most domestic corporations and many foreign corporations held in taxable accounts qualify. Ordinary dividends - paid by REITs, some foreign corporations, and money market funds - are taxed as ordinary income at rates up to 37%. A $10,000 payment from a REIT to a retiree in the 22% bracket is taxed at 22%. The same $10,000 from a dividend-paying S&P 500 stock in a taxable account might be taxed at 0% or 15%. Bond interest is ordinary income. Interest from Treasury bonds, corporate bonds, and most bond funds is taxed at your marginal rate. A retiree in the 24% bracket receiving $10,000 in bond interest pays $2,400 in federal tax on that income - every year. Municipal bond interest is an exception: interest from bonds issued within your state of residence is typically exempt from both federal and state income tax. The tax-equivalent yield of a 4% municipal bond for someone in the 24% bracket is 5.26% - meaning a taxable bond would need to yield 5.26% to equal the after-tax return of the 4% muni. Royalty income from intellectual property or mineral rights is ordinary income at rates up to 37%. If the royalty payer classifies you as actively involved in the business, it may also be subject to self-employment tax on top of income tax.

Rental Income: The Depreciation Shelter and Its Limits

Rental real estate income is ordinary income at rates up to 37%, but it comes with a powerful tax shelter: depreciation. The IRS allows residential rental property to be depreciated over 27.5 years. On a $300,000 property (excluding land value), the annual depreciation deduction is approximately $10,909. This deduction shelters $10,909 of rental income from federal tax every year, effectively creating a paper loss that offsets taxable rental revenue. A rental property generating $18,000 per year in gross rent, after expenses and depreciation, might show zero or negative taxable income on paper - even though the owner received actual cash rent payments. This is the depreciation advantage that makes real estate attractive as a retirement income source. The catch is passive activity loss rules. If your rental activity generates paper losses (expenses plus depreciation exceed rental income), you can only deduct up to $25,000 of those losses against other income if your adjusted gross income is below $100,000. The deduction phases out completely by $150,000 MAGI. Above that threshold, unused passive losses carry forward and are only recognized when the property is sold. For retirees with income above $150,000 from other sources, the depreciation deduction may not provide current tax savings at all. The losses accumulate but sit in limbo until the property sells. At that point, all the accumulated depreciation is subject to recapture at 25% federal tax rate when the property is sold, creating a concentrated tax event.

The Net Investment Income Tax You May Not Know About

A 3.8% surcharge called the Net Investment Income Tax applies to investment income above certain thresholds. In 2026, the NIIT applies once modified AGI exceeds $200,000 for single filers or $250,000 for married couples filing jointly. This tax applies to qualified dividends, ordinary dividends, interest income, rental income, capital gains, and royalties. For a retired couple with $280,000 in combined income - from Social Security, IRA distributions, and investment accounts - the NIIT applies to net investment income above the $250,000 threshold. If $40,000 of that income is investment income, approximately $30,000 of it may be subject to the additional 3.8% tax, adding $1,140 to their tax bill. The NIIT stacks on top of regular income tax and the 3.8% is in addition to any long-term capital gains tax. For a high-income retiree selling appreciated investment property, the combined federal tax on the gain could be 15% long-term capital gains rate plus 3.8% NIIT plus 25% depreciation recapture on any depreciation taken - a combined rate exceeding 40% on portions of the transaction. Roth IRA withdrawals and properly structured life insurance policy loans are excluded from NIIT calculations. This exclusion is one of the genuine tax advantages of building Roth balances or other tax-free income sources - they stay off the MAGI calculation that triggers NIIT, Social Security taxation, and IRMAA.

Building a Tax-Efficient Passive Income Mix

The practical goal is matching the right income sources to the right account types and managing the overall income mix to minimize blended tax rates. Qualified dividends work best in taxable accounts for lower and moderate-income retirees who can stay in the 0% long-term capital gains bracket. In 2026, a married couple can have taxable income up to approximately $96,700 and pay 0% on qualified dividends. Keeping other taxable income modest preserves this 0% opportunity. Bond interest generates ordinary income and creates phantom tax drag in taxable accounts. Placing bonds in tax-deferred accounts like traditional IRAs keeps the interest sheltered from current tax, while allowing tax-efficient equities to grow in taxable accounts where they benefit from step-up in basis at death. Municipal bonds are the exception - they belong in taxable accounts where their tax-free interest provides the most benefit. Holding munis inside an IRA wastes their tax exemption, since all IRA withdrawals are taxed as ordinary income regardless of the underlying investment. Rental properties with substantial depreciation provide tax-sheltered cash flow but create a future recapture liability. Structuring a 1031 exchange at the time of sale - swapping one property for another of equal or greater value - defers the capital gains and recapture taxes indefinitely. For retirees who plan to hold rental properties until death, the step-up in basis provision eliminates capital gains entirely for heirs, though depreciation recapture is not eliminated by a step-up. The most tax-efficient passive income portfolio for a retiree is not the one with the highest gross yield. It is the one with the best after-tax yield given the retiree's specific income level, account structure, and state tax situation.