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 self-employed business is earned income. This includes:
Wages
Salaries
Tips
Bonuses
Commissions
Earned income is taxed at the taxpayer’s marginal tax bracket. As discussed in a previous chapter, U.S. income tax 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
Proceeds from real estate sales
Investment income
Money you receive from investments is investment income. Investment income is often grouped into three main forms:
Qualified dividends are taxed at lower rates (0%, 15%, or 20%) than non-qualified dividends (up to 37%).
Interest is generally taxable at the investor’s tax bracket.
For capital gains, investors net realized gains and losses to determine the taxable amount. 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 during 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 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
The investor now has a $13,000 net capital loss ($2,000 + $5,000 − $20,000).
A net capital loss can reduce taxes in two ways:
The investor can deduct up to $3,000 of net capital losses against earned income in the current year.
Any remaining loss carries forward (“rolls over”) to future years.
For example, if the investor earned $100,000 from their job, they could deduct $3,000 and reduce taxable income to $97,000.
In this example, $10,000 of the $13,000 net capital loss remains. That $10,000 rolls over to the next year and can offset future capital gains. If the investor has $10,000 of capital gains the next year, the rolled-over $10,000 capital loss offsets it, resulting in no capital gains tax on that amount.
Passive income
Income from a business you don’t manage or actively control is passive income. Passive income commonly comes from:
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 types of income. As discussed in the DPP chapter, limited partnerships can pass through losses to investors, and many businesses have 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 other taxable income and potentially eliminate their tax liability.
Tax filing status suitability
Tax filing status suitability means selecting the most beneficial investment strategy for a client’s tax situation, since tax status affects income tax liability.
A common example is a single father who qualifies to file as head of household rather than filing as single. This can be beneficial because head of household status generally provides lower tax rates and a higher standard deduction than filing as single. Suitability also considers dependent care credits, deductions, and earned income.
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