Types of income

There are three basic categories of income a person can receive, and each is taxed differently. For tax purposes, it’s important to know how the Internal Revenue Service (IRS) classifies each type.

Earned income

Money you receive from working at a job or running a business as a self-employed person is earned income. This includes:

• Wages
• Salaries
• Tips
• Bonuses
• Commissions

Earned income is taxed using the taxpayer’s marginal tax bracket. As discussed in a previous chapter, the U.S. income tax system is progressive, meaning higher levels of income are taxed at higher rates.

The IRS does not treat the following as earned income:

• Social security
• Unemployment benefits
• Alimony
• Child support
• Retirement benefits

Investment income

Money you receive from investments is investment income, also called portfolio income. Even though investments can generate returns in many ways, investment income is usually grouped into three forms:

• Dividends
• Interest
• Capital gains

Interest and dividends are taxed as we discussed previously:

• Qualified dividends are taxed at lower rates (0%, 15%, or 20%).
• Non-qualified dividends are taxed at ordinary income rates (up to 37%).
• Interest is generally taxed at the investor’s ordinary income tax bracket.

For capital gains, investors net realized gains and losses to determine whether they have a taxable gain or a deductible loss. Here’s an example:

January 30th

• Sold ABC stock for a $2,000 capital gain

March 15th

• Sold BCD stock for a $5,000 capital gain

July 10th

• Sold CDE stock for $3,000 capital loss

If these are the only trades for the year, the investor has a $4,000 net capital gain ($2,000 + $5,000 − $3,000). The investor owes tax on the net gain. The tax rate depends on whether the gains are:

• Long-term (0%, 15%, or 20%), or
• Short-term (up to 37%).

What if the investor ends the year with a net capital loss? Use the same figures, but change the July 10th trade:

January 30th

• Sold ABC stock for $2,000 capital gain

March 15th

• Sold BCD stock for $5,000 capital gain

July 10th

• Sold CDE stock for $20,000 capital loss

Now the investor has a $13,000 net capital loss ($2,000 + $5,000 − $20,000).

A net capital loss can reduce taxes. If an investor has a net capital loss, they can deduct up to $3,000 of that loss against earned income in the current year. For example, if the investor earned $100,000 from their job, they could deduct $3,000 and reduce taxable income to $97,000. That deduction lowers the tax owed.

In this example, $10,000 of the $13,000 net capital loss remains. Any unused portion carries forward (or “rolls over”) to future years. That carryforward can offset future capital gains. For instance, the investor could realize $10,000 of capital gains the next year and owe no capital gains tax on those gains because the $10,000 carried-forward loss offsets them.

Passive income

Income from a business you don’t manage or actively control is passive income. Passive income commonly comes from:

• Rental real estate properties
• Limited partnerships

Passive income tax rates are the same as ordinary income tax rates, but passive income is tracked separately for an important reason: passive losses can only offset passive gains.

The IRS keeps passive income in its own category to limit the ability of high-income taxpayers to use passive losses to reduce taxes on other income. As discussed in the DPP chapter, limited partnerships can pass through losses to investors, and many businesses generate significant losses in their early years. If passive losses could offset earned or portfolio income without restriction, investors could use large limited partnership losses to reduce (or eliminate) taxes on wages, interest, dividends, and other income.