Active income refers to the earnings an individual receives from wages, salaries, commissions, bonuses, and activities in which they actively participate. This is in contrast to portfolio income, which includes earnings from investments like interest and dividends, and passive income, which encompasses rental income and income from businesses where the taxpayer does not materially participate.
Types of Active Income
Salaries
Salaries are fixed regular payments, typically received on a monthly or bi-monthly basis. They are often expressed on an annual basis.
Wages
Wages are typically paid on an hourly basis and may vary based on the number of hours worked.
Commissions
Commissions are payments received as a percentage of sales made or deals closed. This type of income is common in sales positions.
Bonuses
Bonuses are additional payments made to employees, often at the discretion of the employer, based on performance metrics or company profitability.
Taxation Considerations
Active income is generally subject to federal, state, and local income taxes, as well as Social Security and Medicare taxes. The taxpayer is required to report this income on their tax return using forms such as the W-2 for employed individuals.
Examples of Active Income Reporting
- W-2 Form: Employed individuals report their salaries and wages.
- 1099-NEC Form: Independent contractors report their earnings.
Comparisons with Other Income Types
Passive Income
Passive income includes earnings from rental properties, limited partnerships, or other enterprises in which an individual is not actively involved. According to IRS regulations, passive losses cannot typically be offset against active income.
Example: Rental income from real estate.
Portfolio Income
Portfolio income includes earnings from investments such as interest, dividends, and capital gains. This type of income is generally subject to different tax rules than active income.
Example: Dividends from stock investments.
Special Considerations
Material Participation
For income to be classified as active, it is essential that the taxpayer materially participates in the activity generating the income. The IRS provides tests to determine what constitutes material participation.
Self-Employment
Self-employed individuals earning active income must pay self-employment tax, which includes both the employer and employee portions of Social Security and Medicare taxes.
Deductions and Credits
Certain work-related expenses can be deducted from active income, and several tax credits may apply to those who earn this type of income, such as the Earned Income Tax Credit (EITC).
FAQs
Can passive losses be used to offset active income?
Is Social Security considered active income?
How can I minimize taxes on active income?
References
- Internal Revenue Service (IRS). “Publication 550, Investment Income and Expenses.”
- Internal Revenue Service (IRS). “Publication 925, Passive Activity and At-Risk Rules.”
- Tax Foundation. “Guide to Taxes in the United States.”
Summary
Active income encompasses earnings from employment and other active engagements, including wages, salaries, and commissions. Proper classification and understanding of income types are crucial for accurate tax reporting and strategic financial planning. This category of income is subject to specific tax rules and limitations on how passive losses and portfolio income can interact with it. Understanding these nuances ensures compliance and potential optimization of tax liabilities.
By comprehending the essentials of active income, taxpayers can better navigate their financial obligations and leverage potential deductions and credits to their benefit.
