There are basically three types of income: earned, portfolio, and passive. When it comes to filing your tax return, each of these types of income are taxed differently. Therefore, it is worth understanding the difference between the three to minimize your tax burden. Below are the three types of income, how they are categorized, and the tax implications for each.
This is the easiest income type to identify. Earned income is compensation from employment or the actual involvement of a business. This type of income includes your salary, wages, tips, etc.
Earned income is the most taxed form of income. With personal tax rates ranging from 10% to 35%, this amount can easily add up. Earned income is also subject to other taxes as well, such as social security and Medicare taxes, which are 12.4% (half paid by employer) and 1.45%. Therefore, earned income can be taxed at almost a rate of 50%!
Another disadvantage in regards to taxes when it comes to earned income is the limited amount of deductions available. When compared to passive income, deductions on earned income are less plentiful.
Earned income is sometimes referred to as active income.
Portfolio income is derived from investments and includes capital gains, interest, dividends, and royalties. Various types of portfolio income are taxed differently. For example, capital gains on investments held for longer than 12 months are taxed at a rate of 10% to 20%, and those held for less than 12 months are taxed as regular income. However, portfolio income is not subject to social security and Medicare taxes.
One of the major benefits of capital gains is that it can be offset by losses on other investments. Therefore, if one stock earns $10,000 and another loses $9,000, your capital gain based on that information alone would only be $1,000.
This type of income comes from activities in which you do not actively participate. Such activities include income from real estate and certain business arrangements, such as limited partnerships.
Special rules regarding passive activity losses were enacted in 1986 to limit the amount you could reduce your tax liability from passive income. However, you can still reduce your non-passive income up to $25,000 if your income is below $150,000 and you actively participate in passive rental real estate activities. This amount is phased out between $100,000 and $150,000. Other than this exception, you may only claim losses up the amount of income from the activity. Losses that can not be claimed are carried forward until the property is disposed of or there is adequate income to offset the loss. Real property and other types of investments, if they qualify, may also be used in a 1031 exchange to avoid paying taxes on the income from the sell of the property. This only applies if the proceeds from the sell are used to purchase a similar investment.