Types of income

There are three basic types of income a person can obtain, all of which are taxed differently. It’s essential to understand how the Internal Revenue Service (IRS) treats each of the following:

• Earned income
• Investment income
• Passive income

Earned income

Earned income represents income received from a job or 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. In the previous section, we discussed how 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 an individual earns money from an investment, it’s considered investment income. We’ve discussed dozens of different securities and the various ways they make returns for investors, but investment income can be condensed into three forms:

• Interest
• Dividends
• Capital gains

Interest and dividends are taxable in the ways we discussed in the previous chapter. At the end of each year, investors must net out their capital gains and losses to determine if they owe taxes. Let’s work through 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 three trades were the only ones placed during the year, the investor has a $4,000 net capital gain (gains are netted against losses). The net gain is taxable to the investor. Of course, the tax rate depends on whether the gains were long-term (0%, 15%, or 20%) or short-term (up to 37%).

What happens if there’s a net capital loss for the year? Let’s use the same figures, but tweak 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 ends with a $13,000 net capital loss. Losing money on an investment is never fun, but capital losses reduce taxes. If an investor has a net capital loss for the year, they can deduct up to $3,000 of the capital loss against other forms of income that year. For example, assume this investor made $100,000 of earned income from their job. They can deduct $3,000 from their net capital losses to reduce their taxable earned income to $97,000. The deduction results in a lower tax obligation.

In this example, $10,000 of the $13,000 net capital loss is leftover. Any leftover portion “rolls over” to the following year, which helps the investor avoid taxes on future gains. The investor could make $10,000 of capital gains the following year and not pay any capital gains taxes (the rolled-over $10,000 capital loss offsets it).

Passive income

Income received from a business in which a person does not “materially participate in” is considered passive. Passive income is typically obtained when an investor receives income from rental real estate properties and limited partnerships. While passive income tax rates are the same as income tax rates, they’re categorized as passive for a 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 the real world, businesses often report losses in their first few years of operation. Suppose passive income wasn’t categorized the way it currently is. In that case, investors could rack up significant losses on limited partnership investments, offset their earned or portfolio income with those losses, and effectively pay no tax. Passive income was created as a type of income (in its own category) to avoid the problem of wealthy investors avoiding all taxation.