Understanding how different types of income are taxed can make a big difference in how much you owe or how much you can save. The IRS categorizes income into three main types: earned, passive, and portfolio income. Each type is taxed differently and comes with its own rules for deductions and exemptions. Knowing where your income falls can help you plan better, reduce tax liability, and use smart tax strategies.
Earned Income: How It’s Taxed
Earned income includes wages, salaries, tips, and self-employment income. If you receive a paycheck from an employer or run your own business, this is the category under which your income falls.
Tax Treatment of Earned Income
- Subject to federal and state income taxes
- Includes Social Security and Medicare (FICA) taxes
- Self-employed individuals must pay both the employer and employee portions of Social Security and Medicare taxes
Tax Strategies for Earned Income
Passive Income: What You Need to Know
Passive income comes from rental properties, limited partnerships, and businesses in which you do not actively participate.
Tax Treatment of Passive Income
- Generally taxed as ordinary income.
- Passive losses can only be used to offset passive income (not earned income).
D.C. and Maryland Tax Considerations
- D.C.: Rental income is taxed as business income and requires registration with the Office of Tax and Revenue (OTR).
- Maryland: Short-term rental income is subject to a 6% sales tax, and some counties impose additional lodging taxes.
Tax Strategies for Passive Income
- Consider real estate professional status: If you spend enough time managing rental properties, income may qualify as nonpassive, allowing for additional deductions.
- Take advantage of depreciation: Rental property owners can deduct depreciation expenses to reduce taxable income.
Portfolio Income: How Investments Are Taxed
Portfolio income includes capital gains, interest, and dividends from investments.
Tax Treatment of Portfolio Income
- Short-term capital gains (assets held less than a year) are taxed at ordinary income rates.
- Long-term capital gains (assets held over a year) qualify for lower tax rates (0%, 15%, or 20%).
- Qualified dividends are taxed at the lower capital gains rate, while nonqualified dividends are taxed as ordinary income.
D.C. and Maryland Considerations
- D.C. taxes capital gains at the same rate as ordinary income, which can result in higher tax bills for investors.
Tax Strategies for Portfolio Income
- Time asset sales strategically: Selling long-term investments when your income is lower can reduce capital gains tax rates.
- Offset gains with losses: Selling underperforming investments can help balance out capital gains taxes.
How a CPA Can Help You Optimize Your Tax Strategy
Each type of income is taxed differently, and the right tax strategy depends on your unique financial situation. A CPA can help you:
- Structure income in a way that maximizes deductions and lowers taxable income
- Ensure compliance with D.C., Maryland, and federal tax laws
- Identify opportunities to reduce capital gains taxes
- Develop a tax strategy tailored to long-term financial goals
Plan Ahead for a Stronger Financial Future
Taxes can take a significant portion of your earnings, but with careful planning, you can keep more of what you earn. Whether your income comes from a job, investments, or rental properties, understanding how different income types are taxed can help you make informed financial decisions.
Myrick CPA offers expert tax planning services to help individuals and business owners navigate tax laws, maximize deductions, and minimize liability. Contact Myrick CPA to develop a tax strategy that works for you.