Three Types of Income

In the United States, the IRS classifies income into three main types for taxation purposes. Which category a dollar lands in determines the rate it pays, and most planning is the work of moving dollars between them. Taxable income includes wages, salaries, bonuses, and tips, while nontaxable income encompasses gifts, inheritances, and certain employee benefits. According to IRS Pub. 525, “Taxable and Nontaxable Income”, income is categorized into three major types:

Active (Ordinary, Earned) Income

This category includes all the money you receive from working, such as wages, salaries, bonuses, and tips. It also encompasses income connected with the active conduct of a trade or business, like self-employment income for those who run their own businesses or work as freelancers. Active income is subject to both income taxes and payroll taxes, which fund Social Security and Medicare.

Investment Income

Often referred to as unearned income, this classification covers the money you make from assets you own. Key examples include interest from savings accounts, dividends from stocks, and capital gains from the sale of investments at a profit. Investment income is taxed differently than earned income, with capital gains tax rates generally being lower than the standard income tax rates, depending on how long you’ve held the asset before selling it. More details are in IRS Pub. 550, “Investment Income and Expenses”.

Passive Income

This type of income arises from ventures in which you are not actively involved on a day-to-day basis. It includes earnings from rental properties, limited partnerships, and other enterprises where your participation is minimal. While passive income is subject to income tax, it benefits from deductions such as depreciation that can produce paper losses; those losses, however, are constrained by the passive-activity-loss rules of IRC §469 and generally only offset other passive income (see section “Rental Income Deductions”).

These three baskets are the loss axis of the framework introduced in section “Income”: they govern what can offset what. They are independent of the character axis, which governs the rate. A single activity can produce ordinary income in the passive basket (rental profit), long-term capital gain in the portfolio basket (selling a stock), and IRC §1231 gain in the active basket (selling business equipment) — three different rates, three different loss treatments, one taxpayer.

Two clarifications on the standard telling. First, not every dollar sorts neatly into one of the three: tax-exempt municipal interest, excluded gifts under IRC §102, and excluded gain under IRC §121 never enter the system at all, and 1231 gains are their own hybrid. Second, the preferential rate schedule is not simply “15% or 20%.” Under IRC §1(h) it runs 0%, 15%, and 20% by bracket, plus 25% on unrecaptured IRC §1250 gain and 28% on collectibles, with the 3.8% NIIT of IRC §1411 layered on top of most of it (section “Net Investment Income Tax (NIIT)”).

Categorization matters for two reasons: different rates apply to each character, and the “bucket rule” limits your ability to write off losses in one basket against gains in another.