Types of income

The U.S. tax code sorts income into three broad types — earned, passive, and portfolio — and the classification matters because each type is taxed differently and follows different rules about which losses can offset which gains.

Earned income (also called active income) is compensation for work: wages, salaries, tips, bonuses, commissions, and self-employment income. It is taxed at ordinary income rates and is the only type of income that counts toward contributing to retirement accounts like IRAs.

Passive income comes from business activities in which the taxpayer does not materially participate — most commonly rental real estate and limited partnership interests. Its defining tax rule is that passive losses can only offset passive income; they generally cannot shelter earned or portfolio income. Portfolio income, by contrast, is generated by investments: interest, dividends, and capital gains from selling securities. Qualified dividends and long-term capital gains often receive preferential tax rates, while interest and short-term gains are taxed as ordinary income.

For example, an investor with a $5,000 loss from a limited partnership cannot use it to reduce her salary income — she must carry it forward until she has passive income to offset. Understanding these distinctions is a core tax topic on securities exams: the SIE, Series 7, and Series 65 all test the three types of income, how each is taxed, and the passive-loss limitation rule.