Understanding the Three Types of Income for Tax Purposes: Earned, Passive, and Portfolio
When it comes to taxes, not all income is treated the same. In fact, the IRS classifies income into three main types—earned, passive, and portfolio income—and each is taxed differently. Whether you're a business owner, real estate investor, or simply looking to get a better handle on your finances, understanding these categories can help you plan smarter and avoid surprises at tax time.
ACTIVE INCOME
Income from your day-to-day grind
1. Earned Income: The Workhorse of W-2s and Self-Employment
What it is:
Earned income is the money you make by actively working. This includes wages, salaries, tips, bonuses, and income from self-employment or freelance work. If you're clocking in hours and getting paid for your time and effort, you're earning earned income.
Tax implications:
Earned income is subject to ordinary income tax rates and, in most cases, payroll taxes like Social Security and Medicare. For W-2 employees, these are withheld automatically. Self-employed individuals are responsible for paying both the employer and employee portions of these taxes—known as self-employment tax.
Examples:
A marketing director earning a $120,000 salary
A freelance graphic designer billing clients for projects
A barista earning hourly wages plus tips
passive income
Making money while you sleep
2. Passive Income: Earnings from a Distance
What it is:
Passive income is generated from activities in which you’re not actively involved on a day-to-day basis. The most common sources are rental properties and certain types of business activities where you’re not a material participant.
Tax implications:
Passive income is also taxed at ordinary income tax rates, but it’s not subject to payroll taxes. However, losses from passive activities can generally only be used to offset other passive income—not earned or portfolio income. This makes tax planning around passive income important, especially for real estate investors.
Examples:
Rental income from investment properties
Earnings from a business you co-own but don’t manage
Royalties from intellectual property you created but no longer actively manage
Portfolio Income
The money that makes itself grow
3. Portfolio Income: Your Money Making Money
What it is:
Portfolio income comes from investments—think dividends, interest, and capital gains. This type of income results from your money working for you, not your time or active effort.
Tax implications:
Portfolio income enjoys some favorable tax treatment:
Qualified dividends and long-term capital gains are typically taxed at lower rates (0%, 15%, or 20%) depending on your income level.
Short-term capital gains (on assets held for less than a year) are taxed at ordinary income rates.
Interest income (like from a savings account or bond) is taxed at ordinary income rates.
Examples:
Selling stocks for a profit
Receiving dividends from mutual funds
Earning interest on a high-yield savings account
Why It Matters
Understanding these categories can help you:
Make smarter investment decisions
Strategically manage rental or side hustle income
Plan for tax-efficient retirement withdrawals
Understand how losses in one area might (or might not) reduce your overall tax liability
When you understand how your income is classified, you gain more control over how it's taxed. And with better tax planning, that can translate into more money in your pocket.Need help categorizing or optimizing your income for tax purposes?
We’re here to help you navigate the complexities and make confident financial decisions. Reach out to us for a personalized consultation.
