Tax and Income Categories Information Needed for the Series 7 Exam

By Steven M. Rice

The many lines you see on tax forms clue you in to the fact that the IRS likes to break things down into categories. The following sections explain progressive and regressive taxes, as well as types of personal income.

Touring the tax categories

The supreme tax collector (the IRS) has broken down taxes into a couple categories according to the percentage individuals pay. Your mission is to understand the different tax categories and how they affect investors:

  • Progressive taxes: These taxes affect high-income individuals more than they affect low-income individuals; the more taxable money individuals have, the higher their income tax bracket. Progressive taxes include taxes on personal income, gift taxes, and estate taxes. The Series 7 contains more questions on progressive taxes than on regressive taxes.

  • Regressive taxes: These taxes affect individuals earning a lower income more than they affect people earning a higher income; everyone pays the same rate, so individuals who earn a lower income are affected more because that rate represents a higher percentage of their income. Examples of regressive taxes are payroll, sales, property, excise, gasoline, and so on.

Looking at types of income

The three main categories of income are earned, passive, and portfolio. (If you’re especially interested in the details of how investments are taxed, you can find more information at the IRS website) You need to distinguish among the different categories because the IRS treats them differently:

  • Earned (active) income: People generate this type of income from activities that they’re actively involved in. Earned income includes money received from salary, bonuses, tips, commissions, and so on. Earned income is taxed at the individual’s tax bracket.

  • Passive income: This type of income comes from enterprises in which an individual isn’t actively involved. Passive income includes income from limited partnerships and rental property. When you see the words passive income on the Series 7 exam, immediately start thinking that the income comes from a limited partnership (DPP). Passive income is in a category of its own and can only be written off against passive losses.

  • Portfolio income: This type of income includes interest, dividends, and capital gains derived from the sale of securities. The following section tells you more about taxes on portfolio income. Portfolio income may be taxed at the investor’s tax bracket or at a lower rate, depending on the holding period.

Note: Gifts and inheritances are not considered income.