Difference Between Earned, Passive, and Investment Income

The Internal Revenue Service (IRS) organizes money into distinct categories. This classification is a foundational element of tax planning because how income is categorized dictates how it is taxed, which directly impacts financial outcomes. Understanding the differences between earned, passive, and investment income is necessary to navigate the U.S. tax system.

Earned Income Explained

Earned income is money received for services you personally provide. This category includes wages, salaries, tips, commissions, and bonuses paid by an employer. For those who are self-employed, it represents the net earnings derived from their business or independent contractor work.

Earned income is subject to multiple layers of taxation. It is subject to ordinary income tax, with rates determined by your filing status and which tax bracket your total income falls into. For 2025, these brackets range from 10% to 37%. An employee will see these taxes withheld from their paycheck, as detailed on their annual Form W-2, Wage and Tax Statement.

Beyond income tax, earned income is uniquely subject to payroll taxes. Employees pay Federal Insurance Contributions Act (FICA) taxes, which are composed of a 6.2% Social Security tax on income up to an annual limit ($176,100 in 2025) and a 1.45% Medicare tax with no wage limit. Employers match these contributions.

Self-employed individuals pay a similar tax, the Self-Employment (SE) tax, which combines the employee and employer portions for a total of 12.4% for Social Security and 2.9% for Medicare on their net earnings. While other income types are subject to income tax, they are not subject to FICA or SE taxes. This makes the tax burden on earned income often higher than on other forms of income.

Passive Income Explained

Passive income is generated from an enterprise in which you do not materially participate. The IRS defines material participation as being involved in the operations of the business on a regular, continuous, and substantial basis. If your involvement is minimal, the income is considered passive.

The most common examples of passive income sources are rental real estate activities and income from businesses where you act as a silent partner or a limited partner. If you own a rental property but hire a management company to handle all tenant interactions, maintenance, and rent collection, the net rental income you receive is passive. Similarly, investing money in a business as a limited partner, where you have no management authority, generates passive income.

Passive income is taxed at your ordinary income tax rates, but the rules for deducting losses are restrictive. If your passive activities generate a net loss for the year, you cannot use that loss to offset your earned or investment income.

Instead, these passive losses are suspended and carried forward to future years. You can then use these suspended losses to offset passive income in those subsequent years. The purpose of the PAL rules is to prevent taxpayers from using losses from passive investments to reduce the tax liability on their primary earned income.

Investment Income Explained

Investment income, also called portfolio income, is money generated from your financial assets rather than from direct labor or a passive business. This income is a return on your capital.

Interest

Interest income includes earnings from savings accounts, certificates of deposit (CDs), and corporate or government bonds. For tax purposes, most interest income is taxed at your ordinary income tax rates. You will receive a Form 1099-INT from the financial institution that paid you the interest, detailing the total amount to report on your tax return.

Dividends

Dividends are distributions of a company’s profits to its shareholders. From a tax standpoint, they are separated into two categories: qualified and non-qualified. Non-qualified dividends are taxed at ordinary income tax rates. Qualified dividends, which must meet specific criteria, such as being paid by a U.S. corporation or a qualifying foreign entity and you having held the stock for a certain period, are taxed at lower, long-term capital gains rates. These preferential rates are 0%, 15%, or 20%, depending on your taxable income.

Capital Gains

A capital gain occurs when you sell a financial asset—such as a stock, bond, or piece of real estate—for more than your “basis,” which is what you paid for it. The tax treatment of capital gains depends on how long you held the asset before selling it. If you held the asset for one year or less, the profit is a short-term capital gain, which is taxed at your ordinary income tax rate. If you held the asset for more than one year, the profit is a long-term capital gain and is taxed at the same preferential 0%, 15%, or 20% rates as qualified dividends.

Individuals with significant investment income may be subject to the Net Investment Income Tax (NIIT). This is a 3.8% tax that applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds certain thresholds.