There are three basic types of income a person can receive, and each is taxed differently. It’s important to understand how the Internal Revenue Service (IRS) treats each of the following:
Earned income
Investment income
Passive income
Earned income
Earned income is income you receive from working at a job or operating a self-employed business. The IRS considers all of the following earned income:
Wages
Salaries
Tips
Bonuses
Commissions
Earned income is taxed at each taxpayer’s marginal tax bracket. Income tax is progressive, meaning the rate rises when more income exists. The IRS does not consider any of the following earned income:
Social security
Unemployment benefits
Alimony
Child support
Retirement benefits
Investment income
When you earn money from an investment, it’s considered investment income. Investment income can be grouped into three forms:
Interest
Dividends
Capital gains
Interest and dividends are taxable in various ways. At the end of each year, investors net (add up) their capital gains and losses to determine whether they have a taxable gain or a deductible loss.
Passive income Income received from a business in which a person does not “materially participate” is considered passive. Passive income is commonly associated with income from rental real estate properties and limited partnerships. While passive income tax rates are the same as income tax rates, passive income is categorized separately for an important reason: passive losses can only offset passive gains. As we learned in the direct participation programs chapters, limited partnerships pass through losses to investors. In practice, businesses often report losses in their first few years of operation. If passive income weren’t separated into its own category, investors could accumulate large limited partnership losses, use those losses to offset earned or portfolio income, and significantly reduce (or eliminate) their tax liability. The passive income rules help prevent that outcome.
Key points
Earned income
Income from employment
Includes wages, salaries, tips, bonuses, and commissions
Taxable at the marginal income brackets
Investment income
Income from securities
Includes interest, dividends, and capital gains
Passive income
Income from rental property and limited partnerships
Passive losses only offset passive gains
There are three basic types of income a person can receive, and each is taxed differently. It’s important to understand how the Internal Revenue Service (IRS) treats each of the following:.