Types of Income

The federal tax code classifies income into three primary categories: active (earned) income, portfolio income, and passive income. Understanding these distinctions is critical for CFP candidates because each type has different tax treatment, loss limitation rules, and planning implications.

The Three Types of Income

Active/Earned Income

Active income (also called earned income) is compensation received for performing services. This includes:

• Wages and salaries
• Tips and bonuses
• Self-employment income
• Commissions
• Alimony received (for divorce decrees executed before 2019)

Tax Treatment:

• Taxed at ordinary income rates (10% to 37% in 2025)
• Subject to FICA taxes (Social Security 6.2% up to the wage base of $176,100 in 2025; Medicare 1.45% plus 0.9% additional Medicare tax on wages over $200,000/$250,000 MFJ)
• Self-employment income is subject to 15.3% self-employment tax (12.4% Social Security + 2.9% Medicare)—half is deductible above-the-line

Key Planning Point: Active income is the most heavily taxed category because it faces both income tax and employment taxes. Self-employed clients pay both the employer and employee portions of FICA.

---

Portfolio Income

Portfolio income is investment income that does not require material participation. This includes:

• Interest (taxable and tax-exempt)
• Dividends (ordinary and qualified)
• Capital gains (short-term and long-term)
• Royalties from intellectual property

Tax Treatment:

2025 Long-Term Capital Gains Rate Thresholds (Taxable Income):

Net Investment Income Tax (NIIT): An additional 3.8% tax applies to net investment income when modified AGI exceeds $200,000 (single) or $250,000 (MFJ).

---

Passive Income

Passive income comes from trade or business activities in which the taxpayer does not materially participate. This includes:

• Rental real estate income (generally passive by definition)
• Limited partnership income
• S corporation income (when not materially participating)
• LLC income (when not materially participating)

Tax Treatment:

• Taxed at ordinary income rates
• Critical rule: Passive losses can only offset passive income—they cannot offset active or portfolio income
• Suspended passive losses carry forward and are fully deductible when the activity is disposed of in a taxable transaction

Material Participation Tests: To convert passive to active income, a taxpayer must meet one of seven tests, the most common being:

• More than 500 hours of participation during the year, OR
• More than 100 hours if no other individual participates more

$25,000 Rental Exception: Taxpayers who actively participate in rental real estate may deduct up to $25,000 of rental losses against non-passive income. This allowance phases out by $1 for every $2 of AGI above $100,000 (completely eliminated at $150,000 AGI).

---

Constructive Receipt Doctrine

Constructive receipt is a fundamental tax timing concept. Income is taxable when it is:

1. Credited to your account
2. Set apart for you
3. Made available without substantial limitations or restrictions

Key Examples:

Planning Application: Non-qualified deferred compensation plans are specifically designed to avoid constructive receipt by making the compensation subject to a substantial risk of forfeiture.

---

Taxation of Social Security Benefits

Up to 85% of Social Security benefits may be subject to federal income tax, depending on the recipient's "provisional income."

Provisional Income Calculation:

Provisional Income = AGI + Tax-Exempt Interest + 50% of Social Security Benefits

2025 Taxation Thresholds:

How to Calculate Taxable Amount:

• If provisional income is below the first threshold: $0 taxable
• If provisional income is between thresholds: Lesser of 50% of benefits OR 50% of amount above first threshold
• If provisional income exceeds second threshold: Up to 85% taxable using a more complex formula

Exam Tip: Married filing separately taxpayers who live with their spouse have NO threshold—up to 85% of benefits is always taxable. This is a common exam trap!

---

Annuity Exclusion Ratio

When receiving payments from an annuity purchased with after-tax dollars, a portion of each payment represents a tax-free return of investment.

Exclusion Ratio Formula:

Exclusion Ratio = Investment in Contract / Expected Total Return

Example:

• Investment in contract: $120,000
• Monthly payment: $1,000 for life
• Life expectancy: 20 years (240 payments)
• Expected total return: $240,000
• Exclusion ratio: $120,000 / $240,000 = 50%
• Tax-free portion per payment: $500
• Taxable portion per payment: $500

Key Rules:

1. Once the annuitant has recovered their entire investment, subsequent payments are 100% taxable
2. If the annuitant dies before recovering their full investment, the unrecovered amount is deductible on the final return
3. The exclusion ratio is fixed at the annuity starting date and does not change

---

Income Classification Summary

Understanding these income classifications helps financial planners develop strategies to minimize taxes through proper income timing, loss utilization, and investment positioning.