As a taxpayer, it’s important to understand the difference between the three main types of income when filing taxes. This article will provide an overview of earned income, passive income, and investment income, as well as how these different sources are taxed.
Earned income is the most common type of income for taxpayers. It includes salary, wages, bonuses, tips or commissions that you receive in exchange for providing services. Any income you earn from working is considered taxable earned income by the IRS and should be reported on your tax return. In addition to reporting your earned income on your tax return, you may also be eligible for certain credits or deductions depending on your situation.
Passive income is generated from activities that do not involve providing services in exchange for payment. Examples of passive income include rent payments (from rental properties), royalties from intellectual property such as books and music, or profits earned from a business in which you are not actively involved in its operations. Passive income is subject to federal and state taxes just like earned income; however, there may be some deductions available if you have expenses related to the source of your passive income (such as mortgage interest paid on rental property).
Investment income includes dividends paid on stocks or bonds held in a portfolio as well as capital gains realized when selling investments such as stocks or real estate. Investment incomes are subject to federal taxes just like other types of incomes; however, they may also be subject to additional taxes depending on their source (for example, stock dividends may be subject to the qualified dividend tax rate). Additionally, there may be ways to reduce your investment-related taxes through various strategies such as investing in tax-advantaged accounts (such as IRAs) or using capital losses to offset capital gains.
Knowing which type of income applies to you is essential when filing your taxes—each type has its own set of rules regarding taxation that can affect how much money you owe at tax time. By understanding the differences between earned, passive and investment incomes and taking advantage of any credits or deductions available to you based on these sources of incomes can help ensure that you pay only what is required in taxes each year. Make sure to speak with a qualified accountant if you have any questions about how these types of incomes are taxed so that you can minimize your tax burden and maximize any potential savings available for each type of incomes.
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