What Are the Three Types of Income?
Understand the fundamental ways income is classified based on its source and effort. Gain clarity for better financial planning.
Income refers to money or other value an individual or entity receives, typically in exchange for goods, services, or investments. Understanding how income is categorized is important for financial purposes, including personal budgeting, investment planning, and tax reporting. Income is not a singular concept but rather encompasses different types, each with its own characteristics and tax implications.
Active Income
Active income is earnings derived from direct involvement in a trade or business where an individual materially participates. This category includes compensation for services performed, such as wages, salaries, tips, and commissions. For self-employed individuals, active income encompasses profits from their business operations, where they are directly involved in day-to-day activities.
This type of income is generally subject to ordinary income tax rates, which can vary significantly based on an individual’s total taxable income. Self-employment earnings, like those from a sole proprietorship or partnership, are also typically subject to self-employment taxes, which cover Social Security and Medicare contributions. The defining characteristic of active income is the ongoing effort and direct engagement required to generate it.
Passive Income
Passive income originates from activities in which the individual does not materially participate, or from certain rental activities. A common example is rental income from real estate where the owner does not actively manage the property daily. Royalties received from intellectual property, such as a book or song, after initial creation and minimal ongoing production, are another instance.
Income from limited partnerships also often falls under the passive category because the limited partner typically does not have active management responsibilities. Passive income is subject to specific tax rules, notably limitations on deducting passive losses. These losses can generally only be offset against passive income, preventing their use to reduce active or portfolio income.
Portfolio Income
Portfolio income is derived exclusively from investments and financial assets. It includes interest earned from sources like savings accounts, corporate bonds, government securities, and certificates of deposit (CDs). Dividends from stock holdings or mutual funds also constitute portfolio income, reflecting a share of company profits distributed to shareholders.
Capital gains from the sale of investments like stocks, bonds, or real estate held for investment purposes, are another significant component. The taxation of portfolio income can vary; for instance, qualified dividends and long-term capital gains often receive more favorable tax treatment, typically taxed at lower rates than ordinary income. The generation of this income depends on the performance and disposition of financial assets.
Active Income
Active income refers to earnings directly derived from services performed or from a trade or business in which an individual materially participates. It includes common forms of compensation like wages, salaries, tips, and commissions. For self-employed individuals, active income also includes net profits from business operations, provided they are actively involved in management or work.
This type of income is generally subject to ordinary federal income tax rates, which are progressive and can range from 10% to 37% in 2025, depending on the taxpayer’s total income and filing status. Independent contractors and self-employed individuals are also typically subject to self-employment taxes, covering Social Security and Medicare contributions. The self-employment tax rate is 15.3%, comprising 12.4% for Social Security and 2.9% for Medicare, applied to net earnings.
Passive Income
Passive income arises from activities in which an individual does not materially participate, or from certain rental activities. A common example is rental income from real estate where the property owner does not actively manage the property. Royalties from intellectual property, such as books or music, can also be considered passive once initial creation is complete and no significant ongoing effort is required.
Income from limited partnerships often falls into this category because limited partners typically do not have active management roles. Passive income has specific tax rules, including limitations on deducting passive losses. Generally, these losses can only be used to offset passive income, not active or portfolio income, though there are limited exceptions, such as for certain rental real estate activities for those with lower modified adjusted gross income.
Portfolio Income
Portfolio income is derived from investments and financial assets. Examples include interest earned from savings accounts, bonds, and certificates of deposit (CDs). Dividends from stock holdings or mutual funds are also classified as portfolio income.
Capital gains from the sale of investments like stocks, bonds, or real estate held for investment purposes, are another component. Different types of portfolio income can be taxed at varying rates. Qualified dividends and long-term capital gains often receive more favorable tax treatment, with rates of 0%, 15%, or 20% depending on the taxpayer’s income. Short-term capital gains, from assets held for one year or less, are taxed at ordinary income rates.