April is Financial Literacy Month, which is an opportunity for young adults to learn more about personal finances. For financial security, it is optimal to have income from multiple sources.
Three types of income that will broaden your financial base are active income, investment income, and passive income.
Each type has its own set of tax rules, which you’ll need to consider when deciding how to invest your money.
Active income, also known as earned income, is the money you receive from a job, including salary, bonuses, wages and tips. It also includes the money you make through self-employment, such as income from a business that you run or income from work you perform as an independent contractor.
Alimony is also considered active income for tax purposes, as is income from some types of retirement funds like 401(k)s, traditional IRAs and pensions. They’re all taxed as active income because they originate from someone’s earned income, even if that person isn’t the recipient of the income.
You will pay taxes on your earned income according to the marginal tax rate associated with your tax bracket. The most recent change to the U.S. tax brackets became effective in 2018 with the passage of the Tax Cuts and Jobs Act. Each bracket is an income range with a tax rate attached to it; you pay a higher rate with each successive bracket.
Assume for this example that you’re filing singly and have a taxable income of $40K after applying all credits and deductions. The tax rate on the first $9,525 that you earn is 10%, so you would pay $952.50 for that portion of your income. You would pay taxes at a rate of 12%, or $3,501, on your taxable income from $9,525 to $38,700. The rate for the remaining $1,300 of your taxable income is 22%, which works out to $286 in taxes. Your total taxes for that year would be the sum of the taxes for each bracket, which is $952.50 + $3,501 + $286 = $4,739.50.
Investment income typically takes the form of interest, capital gains and dividends. Interest income includes money earned from checking and savings accounts, from loans you make to other people, and from CDs and bonds. Most interest income is taxed at the same rate as active income, with municipal bonds being the primary exception. Municipal bonds are exempt from federal income tax and from some state and local taxes.
Capital gains are the profits you receive by selling an asset for more than you paid for it. The length of time you own the asset before selling it is the most important factor in determining how the capital gains are taxed. If you own an asset for no more than a year, capital gains from its sale are considered short-term gains and taxed as earned income. However, capital gains from the sale of assets that you owned for more than a year are long-term gains and taxed at a preferential rate.
Income from long-term capital gains thus provides significant tax advantages. For example, the tax rate is zero on long-term capital gains of up to $38,600 for single filers. This means that single taxpayers don’t pay any taxes at all on capital gains, provided they owned the asset for over a year and the value of the capital gain didn’t exceed $38,600.
The next tax bracket for long-term gains ranges from $38,600 to $425K and has a tax rate of 15%, still less than the rate for earned income in that bracket. A comparison of tax brackets and tax rates shows how favorable the tax law is for people who receive the majority of their income from capital gains rather than from earned income.
The stock dividends that U.S. companies pay are typically taxed like capital gains, meaning you pay the preferential tax rate if you keep the stock for longer than a year. The major exceptions to this rule are stocks whose dividends qualify as passive income; that primarily includes real estate investment trusts (REITs) and limited partnerships.
Passive income is generally any income from a business in which the taxpayer doesn’t materially participate, whether it’s a sole proprietorship, limited partnership, limited liability company or S corporation. Some analysts consider investment income to be a form of passive income, though the IRS does not necessarily agree.
Passive income also includes most income from leasing equipment and real estate, with limited exceptions. Passive income can be taxed as ordinary income or as investment income, depending upon the circumstances.
The IRS uses multiple rules to determine if a taxpayer materially participates in a business. As a result, this determination can become complex, but it primarily depends on the duties a taxpayer performs and on the amount of time spent doing them. Working more than 500 hours in a year generally qualifies as material participation in a business, but lesser participation also can qualify.
For example, working as few as 100 hours in a year can qualify as material participation if no one else works more hours for the business. You will always qualify as a material participant in a business if you’re its only participant.
The rules on material participation are different for real estate activities like REITs. You must qualify as a real estate professional, not as an ordinary worker, and you must provide at least 750 hours of services for the real estate business, the majority of which must be real estate services.
The determination of what qualifies as work within the context of material participation gets complicated, but it generally means that you work for the business rather than merely invest in it. The purpose of these rules on material participation is to prevent investors from using passive-income investments for tax avoidance. Only taxpayers who materially participate in a business are allowed to declare immediate tax deductions on losses sustained by the business.
Figure will be educating readers on earnings and other financial topics during Financial Literacy Month, allowing them to make better decisions on putting their money to work for them. Figure also provides innovative loan products for borrowers.