How Does the IRS View Your Income?
For most of us, income is just one thing: Money coming in for work we do. The IRS, though, takes a different view. It uses a system of different income classifications, and the way yours is classified will decide exactly how much in taxes you pay on it.
Three Types of Income: Active, Portfolio, and Passive
Before you fill out your tax return, it’s a good idea to understand the different types of income that you might have. The IRS recognizes three different types of income, and they are reported in different places on your tax return – and may require that you fill out accompanying forms or schedules.
- Active income: This is the type of income that most of us are familiar with. Earned income, such as that from wages, tips, and business participation are considered active. It is also income from business activities, such as the money you earn if you are self-employed or actively involved in managing a rental property. This is the type of income that can be reduced (offset) by contributions to your 401(k) account and tax deductions.
- Portfolio income: This is income from your investments, including capital gains, interest, and dividends, and it’s possible to offset the income from your portfolio with losses. It’s important to understand that the IRS views portfolio income as distinctly different from passive income, even though it is popularly considered to be “passive.”
- Passive income: Unfortunately, the IRS isn’t too forthcoming about what qualifies as “passive.” It just calls passive income money that you receive that is unrelated to business activity, investment income, or wages. In other words, passive income can be defined as money that you do not actively work to produce. Royalties from a creative effort or the income from licensing a patent are considered passive. Additionally, if you receive money from a rental property you own but don’t actively participate in managing, that’s considered passive income. The IRS does not allow you to use passive losses to offset your active or portfolio income.
As you earn money, it’s important that you consider what kind of income you are receiving, as mistakes could lead to you either paying too much in taxes or underpaying and being subject to an audit.
5 Definitions of Income for Tax Purposes
After addressing the above types of income, the IRS then uses another set of definitions of income when determining your eligibility for certain deductions, as well as defining the amount of money on which you are actually taxed.
- Gross income: This is the amount of money you make before any deductions or reductions are made to it. It’s money you make from wages, tips, business activities, and investments. However, your tax return doesn’t actually start with your gross income.
- Total income: Your total income for tax purposes is what you make after some of your deductions, like HSA contributions and 401k contributions. If you have a regular job, you can use your W-2 to help determine your total income.
- Adjusted gross income: After figuring out your total income, it’s time to make adjustments for more deductions. These are generally the deductions you see on the front of your 1040 form. Business expenses, IRA contributions, moving expenses, student loan interest expenses, and other “above the line” deductions are made. Once these are subtracted from your total income, you have your adjusted gross income, or AGI.
- Modified adjusted gross income: The point of modified adjusted gross income (MAGI) is to determine contribution limits and your maximum deductions allowed for specific accounts. Certain deductions are added back in to determine your MAGI, which often ends up being higher than your AGI.
- Taxable income: Finally, it’s time to figure your taxable income, which is used to determine what you owe. You take the standardized deduction, or itemize your deductions, and subtract the total from your AGI to arrive at your taxable income.
Figuring out your taxes based on these income definitions is part of the tax planning process. Tax software can help you, and if you have more complicated taxes and multiple sources of income, it might make sense to hire a tax professional to help you sort through everything.
Image: erhui1979 / iStock.