Chapter 4
Income

Start with the only sentence in the tax code that describes income as a whole. Under IRC §61, “Gross income defined”, gross income means “all income from whatever source derived.” Everything is taxable unless a specific provision says otherwise. There is no general two-bucket division of income into earned and unearned — that framing appears in popular writing and in a few narrow statutes, and it will mislead you if you build a plan on it.

What actually determines what you owe is a grid with two independent axes, plus a surtax laid across the top.

Axis one: character. Character sets the rate. Ordinary income — wages, interest, rents, business profits, short-term gains — runs up the bracket schedule of IRC §1(a) to 37%. Long-term capital gains and qualified dividends get the preferential schedule of IRC §1(h), “Maximum capital gains rate”: 0%, 15%, or 20%. Two carve-outs sit above that and routinely surprise people: unrecaptured §1250 gain — the part of a real estate gain attributable to depreciation you deducted — is taxed at up to 25% under IRC §1(h)(6), and collectibles gain, including physical gold, is taxed at up to 28% under IRC §1(h)(5).

Axis two: basket. The basket sets whether a loss is usable. IRC §469, “Passive activity losses and credits limited” sorts activity into active, portfolio, and passive, and losses generally stay in their own basket. This is why a $100,000 rental loss cannot offset a $100,000 salary, and why the exceptions to that rule — material participation, real estate professional status, the short-term rental loophole — are worth so much (section “Importing Losses Against Wage Income”).

The overlay: the 3.8% surtax. IRC §1411, “Net investment income tax” adds 3.8% to interest, dividends, capital gains, rents, royalties, annuities, and passive business income once modified AGI exceeds $200,000 single or $250,000 joint. Those thresholds are not indexed for inflation — they have been the same since 2013, which means an ever-larger share of the population pays it every year without Congress voting on anything (section “Net Investment Income Tax (NIIT)”). Wages escape §1411 but pick up the parallel 0.9% Additional Medicare Tax under IRC §3101(b)(2) at the same thresholds.

Put the axes together and the top federal rate on a dollar depends entirely on where it lands: 40.8% on a wage dollar, 40.8% on a short-term trading gain, 31.8% on gold, 28.8% on the depreciation slice of a real estate gain, 23.8% on a long-term gain, and 0% on a municipal bond coupon. Same taxpayer, same year, same amount of economic gain.

Two of those need their arithmetic shown, because readers reconstruct them and get different answers. The wage figure counts the full Medicare burden on the dollar — 1.45% withheld from you, 1.45% paid by your employer out of what it would otherwise have paid you, and the 0.9% surtax — so $37\%+2.9\%+0.9\%=40.8\%$, the same total a self-employed person pays visibly on Schedule SE. Count only the employee’s half and you get 39.35%, which understates what the dollar actually costs to produce. Gold is $28\%+3.8\%$: collectibles gain is capital gain, so the §1411 surtax reaches it exactly as it reaches any other gain, and 28.8% — the number people reach for — is the unrecaptured §1250 rate of $25\%+3.8\%$, a different animal entirely.

Earned income, then, is not a category of the tax system but a defined term used by specific provisions that each define it slightly differently — IRC §32(c)(2) for the earned income credit, IRC §911(d)(2) for the foreign earned income exclusion, IRC §219(f)(1) for whether you may fund an IRA, IRC §1402, “Definitions” for self-employment tax. Where this chapter uses the term, it means compensation for services, and the distinction that matters is almost always whether the item is subject to payroll tax.