What Are the 3 Main Types of Income?

Understanding how income is classified is important for managing personal finances and navigating tax obligations. The tax system categorizes income into distinct types, each with its own rules and implications for taxation.

Ordinary Income

Ordinary income, often called earned income or active income, represents the most common form of earnings for many individuals. This category includes money received from employment, such as wages, salaries, tips, and commissions. Profits generated from a business where the individual actively participates are also considered ordinary income.

This type of income is subject to federal income tax at progressive marginal rates, ranging from 10% to 37% across various tax brackets. It is also subject to payroll taxes, including Social Security and Medicare taxes, often referred to as FICA taxes. For self-employed individuals, these payroll taxes are paid as self-employment tax. Certain unearned income, such as interest from savings accounts and unqualified dividends, are also taxed as ordinary income.

Passive Income

Passive income is defined as earnings from activities in which a person does not materially participate. This category includes rental income from real estate, unless the individual qualifies as a real estate professional. Other examples include income from limited partnerships or royalties from intellectual property.

A key concept distinguishing passive income is “material participation,” which refers to regular, continuous, and substantial involvement in an activity. The IRS provides tests to determine material participation. If these participation thresholds are not met, the income is considered passive. Passive activity loss (PAL) rules mean that losses from passive activities can only offset passive income, and cannot be used to reduce ordinary income from wages or business profits. Any disallowed passive losses can be carried forward to future tax years to offset future passive income.

Portfolio Income

Portfolio income represents earnings derived from investments in financial assets. Examples include interest earned from savings accounts, bonds, and certificates of deposit. Dividends received from stocks and capital gains from the sale of investments also fall under this classification. Unlike ordinary income, portfolio income is not subject to Social Security or Medicare taxes.

The taxation of portfolio income can vary depending on the asset and holding period. Interest income and ordinary dividends are taxed at ordinary income tax rates. However, qualified dividends, which meet specific IRS criteria, are taxed at lower long-term capital gains rates. Capital gains, which are profits from selling an asset for more than its purchase price, are categorized as either short-term or long-term. Short-term capital gains, from assets held for one year or less, are taxed at ordinary income rates, while long-term capital gains, from assets held for over a year, benefit from lower tax rates.