Have you ever wondered why some types of income are taxed more than others? Understanding the different types of income and their tax implications is key to managing your finances effectively. Whether you’re a high-earning professional or just starting your financial journey, this comprehensive guide will empower you to make more informed decisions about your income. A financial advisor can also be a valuable resource as you build income streams and manage your tax liabilities.
What Is Income?
Income, in its simplest form, is money that an individual or business receives in exchange for providing a good or service or through investing capital. It’s the lifeblood of financial planning, allowing us to cover daily expenses, save for future goals and invest for growth.
The importance of income in financial planning cannot be overstated. It’s the foundation on which budgets are built, investments are made and futures are secured. Understanding the different types of income can help you strategically plan your financial activities and make the most of your earnings.
3 Main Types of Income
Income can be categorized into three main types: ordinary income, capital gains and tax-exempt income. Each type comes with its own characteristics and tax implications.
Ordinary income is what most people think of when they consider their earnings. It encompasses wages, salaries, tips and interest earned on a savings account. The key characteristic of ordinary income is its tax treatment. It’s subject to the federal income tax brackets, which can go up to 37% as of 2023. Keep in mind that the federal tax system in the United States is progressive, meaning the more income you earn, the higher your marginal tax rate will likely be.
For example, a person earning $100,000 annually would fall into the 24% federal tax bracket while someone who makes $220,000 per year would be in the 35% tax bracket.
Capital gains refer to the increase in value of an investment or real estate property that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. There are two categories of capital gains: short-term and long-term. Short-term capital gains, from assets held for less than a year, are taxed at the same rate as ordinary income. On the other hand, long-term capital gains from assets held for more than a year enjoy significantly lower tax rates (0%, 15%, or 20% based on income).
Tax-exempt income is income that is free from federal taxes. This includes certain Social Security benefits and interest from municipal bonds. This type of income is designed to achieve certain societal goals, like promoting certain economic activities or providing relief to certain groups. For instance, the interest from municipal bonds is normally tax-exempt to compel investment in public projects. Other types of tax-exempt income include some education scholarships, disaster relief payments and certain types of life insurance proceeds.
Common Examples of Income
While hourly wages are one common example of income, sales commissions and government benefits are others. Each type of income comes with its own tax implications, and a financial advisor could help you navigate these implications to ensure you’re making the most of your earnings. Here are some of the most common examples of income:
Wages refer to the compensation individuals receive from their employers in exchange for their labor or services. This form of income is typically associated with hourly, daily, weekly, or monthly work arrangements, where the employer pays the employee a predetermined amount for the time and effort invested in their job.
While wages are usually paid based on the number of hours worked, salaries are fixed amounts paid on a regular basis regardless of the number of hours worked.
Gross salary is the total amount an employee earns before any deductions, such as taxes, insurance, or retirement contributions. It represents the agreed-upon annual or monthly amount stated in the employment contract. Net salary, on the other hand, is the amount an employee takes home after deductions. It’s the actual income that appears in one’s bank account and can differ from the gross salary due to taxes and other withholdings.
In the world of finance, interest is a fundamental concept that plays a crucial role in both personal and business financial affairs. Interest is a form of income earned by lending money or investing capital. Interest income can come from a savings account, other fixed deposits or bonds.
Commissions represent a versatile form of income, prevalent in various industries and occupations. Commissions are often the compensation that are paid to a person or entity for selling a product or rendering service.
Rather than receiving a fixed salary, sales professionals may be compensated based on the number of products or services they sell. The commission percentage often varies depending on the industry and the specific product sold, incentivizing salespeople to excel and maximize their earnings. Real estate agents and brokers also commonly earn their income through commissions.
Investing can open up a world of income-generating opportunities for individuals looking to secure their financial future. From dividends and capital gains to rental income and interest income, different investments generate different forms of income. Keep in mind that with this variety comes differences in how investments may be taxed. For example, investments that are held for at least a year are taxed as long-term capital gains, while dividends are often taxed as ordinary income.
Gift income refers to monetary or non-monetary contributions that a person receives without any obligation for repayment. These contributions can come from family members, friends or even organizations. While they may not be classified as regular earnings, they can still have a significant impact on an individual’s financial situation.
Gifts can also play a significant role in estate planning. Givers may use gifts as a way to reduce the overall value of their estate, potentially minimizing estate taxes for their beneficiaries. For recipients, gifted assets might have different tax implications compared to inherited assets.
Government payments play a crucial role in supporting many individuals and families. While unemployment benefits can help support a person and their family after they’ve lost their job, Social Security is another type of government payment that plays a vital role in the financial plans of millions of Americans as they age. Supplemental Security Income (SSI), another type of government benefit, supports disabled adults and children, as well as some low-income seniors.
Earned vs. Unearned Income
Income can also be subdivided into earned or unearned income. Earned income includes wages, salaries, bonuses, commissions, while unearned income encompasses interest, dividends and capital gains.
The tax treatment of these types of income differs. Unearned income is potentially subject to the Net Investment Income Tax (NIIT), a 3.8% tax on certain net investment income of individuals, estates, and trusts with income above statutory threshold amounts. For example, a single taxpayer may owe NIIT if their modified adjusted gross income (MAGI) exceeds $200,000, while a married couple filing jointly may be subject to this tax if their MAGI is above $250,000.
Awareness and understanding of the different types of income and their tax implications are crucial for effective financial planning. They form the basis for strategizing your income streams, planning for taxes and making informed decisions about earning, saving and investing. The income you earn can be classified as ordinary income, capital gains or tax-exempt income. While hourly wages and fixed salaries are usually what comes to mind when people think of income, sales commissions, gifts, interest and government benefits are also other examples of income that you may receive throughout your financial journey.
Tips for Filing Your Taxes
- Planning ahead can make tax time that much less stressful. SmartAsset has tools to help you do just that, including an income tax calculator and a tax return calculator. Also be sure to properly fill out your W4 when you start a new job. This paperwork tells your employer how much federal income tax to withhold from your paycheck.
- A financial advisor can also be a valuable resource when it comes to tax planning. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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