If you’re like most of my clients, you don’t just have one source of income. Between your W-2 salary, potential consulting work, stock compensation, rental properties, and investment gains, you’re likely juggling multiple income streams—each with its own tax rules.
Understanding how each type of income is treated from an income tax perspective is crucial for effective tax planning. Without this knowledge, you could miss opportunities to optimize your strategy or, worse, getting surprised by a tax bill that’s larger than you expected. Let me break down the three main categories of income and how the IRS treats each one.
Active Income: The Foundation of Many Tax Bills
Active income is what many people think of when they hear “income”—money you earn from working. But there are important distinctions within this category.
W-2 Employee Compensation
This is the most straightforward income type. Your regular salary and bonuses are subject to:
- Federal income tax (10% to 37% depending on your bracket)
- State and local income tax (varies by state and municipality)
- Social Security tax (6.2% on income up to $176,100 in 2025)
- Medicare tax (1.45% on all income, plus an additional 0.9% on income over $200,000 for single filers)
The key advantage? Your employer pays half of your Social Security and Medicare taxes. When you fill out your W-4, remember to consider all your income sources—not just your salary—to avoid under-withholding.
1099 Income
This is where things get more expensive from a tax perspective. As a 1099 contractor or business owner, you’re responsible for both halves of Social Security and Medicare taxes (known as self-employment tax). That’s 15.3% on the first $176,100 of self-employment income, plus 2.9% Medicare tax on all income.
The silver lining? You can deduct ordinary and necessary business expenses related to your work, which can significantly reduce your taxable income.
Equity/Stock Compensation
Stock compensation comes in many forms, and the tax treatment varies significantly:
- RSUs (Restricted Stock Units): Taxed exactly like salary upon vesting—ordinary income tax rates plus payroll taxes
- NSOs (Non-Qualified Stock Options): No tax until you exercise, then ordinary income tax on the difference between exercise price and fair market value
- ISOs (Incentive Stock Options): More complex—potentially subject to Alternative Minimum Tax (AMT) and capital gains treatment if certain holding periods are met
Passive Income: The Separate Bucket
Passive income—often from rental real estate or limited partnerships—tends to operate much differently. Here’s what makes it unique:
- You pay income tax at ordinary rates on passive income
- You typically don’t pay Social Security or Medicare taxes on truly passive income
- Passive losses can only offset passive income—this is crucial to understand
That last point trips up many real estate investors. If your rental property generates a $10,000 loss, you generally cannot use that loss to reduce taxes on your W-2 income. Passive losses stay in their own bucket and carry forward to offset future passive income.
Note: There are exceptions for active real estate professionals and certain income thresholds, but these are the general rules.
Capital Gains and Losses: Timing Matters
Capital gains occur when you sell a capital asset (stocks, investment property, etc.) for more than you paid. The tax treatment depends entirely on how long you held the asset:
Short-Term Capital Gains (Held One Year or Less)
- Taxed at ordinary income tax rates (up to 37%)
- No preferential treatment
Long-Term Capital Gains (Held More Than One Year)
- Taxed at preferential rates: 0%, 15%, or 20% depending on your income
- Potential additional 3.8% Net Investment Income Tax if you’re above certain income thresholds
Example: If you sell stock for a $100,000 long-term gain and you’re in the 15% capital gains bracket, you’ll owe $15,000 in capital gains tax.
Capital Losses
- Can offset capital gains dollar-for-dollar
- Can offset up to $3,000 of ordinary income per year
- Excess losses carry forward to future years
Additional Considerations
State Tax Implications
Don’t forget about state taxes. Some states have no income tax, while others can add significant tax burden. If you’re considering a move or have income in multiple states, consider factoring this into your planning.
Net Investment Income Tax (NIIT)
High earners (over $200,000 single/$250,000 married filing jointly) may owe an additional 3.8% tax on investment income, including capital gains, dividends, and rental income.
Quarterly Estimated Taxes
If you have significant 1099 income, capital gains, or rental income, you may need to make quarterly estimated tax payments to avoid penalties.
Summary
Understanding how your different income streams are taxed is essential for effective financial planning. Here are the key takeaways:
- Active income (W-2, 1099, stock compensation) faces the highest tax rates and payroll taxes
- Passive income is taxed at ordinary rates but lives in its own bucket—losses can only offset other passive income
- Capital gains receive preferential treatment if held long-term, but losses have limited deductibility
The complexity of multiple income streams is exactly why proactive tax planning matters. By understanding these rules and working with qualified professionals, you can optimize your strategy and avoid costly surprises come tax time.
Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. You should confer with their qualified legal, tax and accounting advisors as appropriate.
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