The Three Types of Incomes and How They’re Taxed
There are many different types of income, and each one has its effect on your taxes. Understanding the different kinds of income and how they are taxed is essential for anyone trying to maximize their tax savings.
In this blog post, we’ll discuss the three most common types of income and how they are taxed. We’ll also provide tips on how to reduce your tax bill by using different types of income. So, whether you are a business owner or just trying to make sense of your tax return, read on for helpful information on income taxes.
What are income types?
In a broad aspect, income types are divided into two categories: active and passive. You can generate active income through wages, tips, or self-employment income. This type of income is considered “earned” since it requires effort to generate.
On the other hand, passive income comes from sources that don’t require active work on your part. This could include interest from investments, dividends from stocks, mutual funds, or rental income from property you own.
You can further break down income types into three categories. The three types of income are active income, passive income, and portfolio income.
1) Active Income
Active income, also known as earned income, is money made from working. It’s the most common type of income, including salaries, wages, tips, and commissions.
2) Passive Income
Passive income is money that you make without actively working for it. It includes rent payments, royalties from intellectual property, dividends from stocks or investments, and business profits distributed to owners who are not actively involved.
3) Portfolio Income
Portfolio income is money that comes from owning assets such as stocks, bonds, real estate holdings, or patents. It doesn’t require active work to maintain and generate the associated revenue stream.
Let’s dig deeper into each income type.
Active income is typically associated with earning money from a job, and it can also come from renting out property or royalties from creative works. However, for property or royalties to be considered “active ordinary income,” you must be materially participating in the property or receive advance payment for products that collect royalties. We’ll discuss this further a little later.
There’s nothing wrong with having an active income, but it does have its limits. The biggest problem with active income is that it stops when you do. If you lose your job, get sick, or otherwise can’t work, your active income disappears. This can be incredibly challenging if you have a family to support or other financial obligations.
Active Income Tax
Another downside of active income is it’s often taxed at a higher rate. Active income can be taxed in a few ways, but commonly people are aware of the federal income tax bracket. Federal income tax, also known as your marginal tax rate, is the percentage tax on your ordinary income. The more money you obtain, the higher the tax percentage of that money.
For example, if you’re in the highest tax bracket of 37%, your federal tax rate will reduce your income by 37%.
Additionally, there’s a Federal Insurance Contributions Act (FICA) tax that both employees and employers must pay on active income. This is a fixed percentage of paid wages. In other words, the FICA tax is a payroll tax that is deducted from your paycheck, which is your Social Security and Medicare Tax.
The Social Security rate of the FICA tax is 6.2%, which each employer and employee must pay on wages up to a specific limit. The Medicare portion of the FICA tax is 1.45% of your wages for both the employer and employee with no maximum limit.
Self-employed workers also have to pay FICA tax, but they are responsible for both the employee and employer portions of the tax. The combined Social Security and Medicare tax rate for self-employed workers is 15.3%, that’s the 12.4% total for social security tax and the 2.9% total for Medicare tax. Not to mention, self-employed individuals also pay taxes on their income at their specific tax bracket.
Now that we’ve got Active income out the way let’s get into the other income types.
There are a few different types of portfolio income, but the most common include royalties, interest income, dividends, and capital gains.
Royalties are payments made to artists for the use of their music, but they can also refer to payments made to authors, inventors, and other creatives for the benefit of their work. In the United States, royalties are typically paid as a percentage of the work’s revenue. For example, an author may receive a 5% royalty on the sales of their books.
Royalties are taxed as ordinary income, and if your marginal tax rate is 10%, you will pay 10% in taxes. Self-employment taxes do not apply to royalties as long as you published the product before receiving payments.
However, if an investor paid you in advance, that payment is subject to federal income tax (depending on your tax bracket) and self-employment taxes (FICA). You must pay both because you earned income while producing the product, making it an active income.
Interest income is simply the money you gain from lending out your investment portfolios. This can come in bonds, which are debt securities that pay a fixed interest rate, or from other sources like peer-to-peer lending platforms.
If you earn more than $10 from a business or person in interest income, you will get a Form 1099-INT. This form tells you how much money in interest you earned. Even if you do not get a 1099-INT, you must always report any amount you receive from interest income on your tax return. There is no minimum amount required, meaning if you received anything above $0, you must report it.
Interest income is taxed at your marginal tax rate and does not incur self-employment tax. You may also pay an extra 3.8% tax on investments, which is called the net investment income tax (NIIT). You will only have to pay net investment income tax if your modified adjusted gross income (MAGI) is over a certain amount.
Dividend income is payments made to shareholders from the profits earned by a company. Publicly traded companies must payout at least 90% of their earnings as dividends, which can be a significant source of passive income for investors.
The amount taxed as Dividend income depends on whether it’s a qualified dividend or a non-qualified dividend. A qualified dividend is taxed as long-term capital gains, whereas non-qualified dividends are taxed as short-term capital gains. We’ll discuss short-term and long-term capital gains in a few.
Capital gains are profits realized when you sell an asset for more than what you paid.
For example, if you bought 100 shares of stock for $10 per share and later sold them for $12 per share, your taxable gain would be $2 per share ($12 sales price minus $10 purchase price). If you held the stock for more than one year, your gain would be considered a long-term capital gain and taxed at a lower rate than ordinary income.
The amount taxed will depend on how long you’ve held the asset. There are two types of gains, long-term and short-term.
Short Term Capital Gains
Short-term gains are profits from the sale of investments you’ve held for one year or less. You will pay taxes at your ordinary-income tax rate (federal tax level).
So, if you’re in the 22% tax bracket, short-term gains are taxed at 22%. If you’re in the 12% bracket, they’re taxed at 12%, and so on. The marginal tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The tax rate is subject to your income level.
Long term Capital Gains
Long-term capital gains are the profit you make after holding onto an investment for more than one year. For instance, if you purchase a stock for $10 and sell it for $21 a year and a day later, your profit would be considered a long-term gain. This is because you owned the stock for more than one year before selling it.
If you sell an asset at a profit after holding it for more than a year, it is taxed at a lower tax rate than if you sell it in less than a year. For example, if you’re in the 24% marginal tax bracket, your long-term capital gains tax rate would be 15% instead of your ordinary-income rate of 24%. Long-term capital rates are taxed at 0%, 15%, and the highest at 20%.
Passive income is a stream of revenue that the taxpayer does not actively generate. There are several ways to create passive income, including owning rental property, investing in mutual funds, or starting a business that doesn’t require much active work.
Rental income includes real estate investment trusts (REITs which are portfolios of rental properties managed by a third party) or simply investing in property yourself and collecting rent from tenants.
The IRS generally considers anything that requires minimal ongoing work on your part to be passive, provided you’re not materially involved in the day-to-day operations.
Most of the dividends from REITs are taxed as ordinary income, up to a maximum marginal rate of 37%. An additional NIIT tax of 3.8% is taxed as investment income. Taxpayers may also generally deduct 20% of the combined qualified business income (QBI) amount as qualified businesses, which includes Qualified REIT Dividends through Dec. 31, 2025.
Rental Income Tax
If you collect rent from tenants, it is taxed the same way as regular income. You will be taxed on this income at a marginal rate, excluding self-employment taxes such as social security and medicare taxes. This is because you are not materially participating in the rental activity and are a silent business owner. HOWEVER, there are a few exceptions to this rule.
Suppose you’re not a business owner and renting out property that you ARE materially participating in. Your rental income will be considered active income and taxed at your regular federal tax rate, including FICA taxes (social security and medicare taxes). This includes renting out a room in your house or an apartment that you live in part-time and providing up-keep services.
Not Material Participate
Suppose your rental activity is considered a business activity you have material participation in; your rental income will be considered active and subject to self-employment tax. This usually applies to people running a bed and breakfast location or hotel-like facilities.
The key is that you are materially participating in the rental property; therefore, you are an active income earner. The only difference between rental property owners who did not materially participate in the rental activity and active income earners who have material participation is activity loss.
Passive Activity Loss
Rental owners who do not actively participate in rental activities may be able to use losses from one year to offset profits from another year. This is called passive activity loss (PAL), and it’s limited to $25,000 per year.
Rental income is considered “ordinary” income, which means it’s subject to the same tax rates as wages, salaries, and other sources of income. You’ll report your rental income on Schedule E of your tax return and pay taxes on it at your regular tax rate. If you have net losses from your rental activities, you can deduct them from your other income on your return. This will lower your taxable income and may reduce the amount.
The three different types of income – Active, Passive, and portfolio can be taxed differently. Active income is subject to your marginal and FICA taxes, whereas investment income is taxed as ordinary income and subject to NIIT tax. Some passive income and portfolio income are broken into short-term and long-term capital gains and are taxed accordingly.
The Long-term gains tax is a tax on the profit from the sale of certain assets, such as stocks, bonds, and real estate. It’s levied at 0%, 15%, or 20%, depending on how long you’ve held the asset. Assets held for less than one year are taxed at your regular income tax rate, while assets held for more than one year are taxed at the long-term capital gains rate.
The long-term capital gains tax encourages investors to hold onto their investments for extended periods since they’ll be taxed at a lower rate. It’s also meant to reduce volatility in the stock market by discouraging short-term trading.
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