How Is Income Taxed? Well, What Do You Mean by ‘Income’?

Personal Finance
How Is Income Taxed? Well, What Do You Mean by ‘Income’?

By Craig Smalley

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Income seems like a simple concept, but when it comes to tax treatment it can actually be quite difficult to understand. The Merriam-Webster dictionary defines income as “money that is earned from work, investments, business, etc.” The term seems straightforward — but that was before Congress got a hold of it. Here’s a quick primer on the different types of income and how they are taxed.

Earned income

This is income you receive from working. Again, it seems simple, but we must expand on that definition. Earned income includes money you make being self-employed — but some people who might consider themselves self-employed do not have earned income.

For instance, if you are a shareholder in an S corporation, the profit from the S corporation that flows through to your personal tax return is not earned income. So what makes this kind of income different? It isn’t subject to Social Security tax.

Using another example, income that you earn as a general partner in a partnership or as a sole-proprietor who files a Schedule C is considered earned income. Why? Because it is subject to self-employment tax, which is just the Social Security and Medicare taxes on self-employment income. The best way to think of earned income is as any income that is subject to Social Security taxes.

Ordinary income

Ordinary income makes up the majority of most people’s income. It includes, but isn’t limited to, earned income. It’s probably easier to list what ordinary income isn’t, rather than what it is. Ordinary income is all income that is not passive income, capital gains income or certain dividend income (explained below). Ordinary income is subject to ordinary income tax rates. The “tax brackets” you hear about refer to the maximum tax rate charged on your ordinary income.

Capital gains income

This one is tricky. Capital gains income is the profit you make on a capital investment. For instance, if you sell stock for more than you paid for it, the difference is capital gains income. Other potential sources of capital gains income include commodities, mutual funds, digital currency or real estate.

Capital gains are either long-term or short-term, depending on how long you owned the investment before selling it. Gains on assets that you held for a year or less are short-term capital gains; the rate you pay is the same as on your ordinary income. Gains on assets you hold for longer than a year are long-term capital gains. They’re taxed at lower rates — 0% or 15% for most people, and 20% for those at higher incomes.

Dividend income

Dividend income is income that you earn on certain investments in the stock market. Dividends are profits that a company shares with its stockholders. There are ordinary dividends, which are taxed at your ordinary income tax rate, and qualified dividends, which must meet certain criteria and are taxed at the lower capital gains rate — 0%, 15% or 20%, depending on which tax bracket you are in.

Passive income

Most taxpayers don’t have this kind of income. Passive income is earned on passive investments. For instance, if you are a limited partner in a partnership or if you do not materially participate in your business’s activities, you have passive income.

Rental income is also considered passive income. Because of expenses like rental property depreciation (a deduction you get to take for wear and tear on your property over a period of time), most rental properties lose money for tax reasons.

Generally, losses from passive activities can only be deducted against passive income, unless you have a rental property. Typically, if your adjusted gross income (see below) is under a certain amount, you can deduct $25,000 of your rental losses. If your income is over that amount, you have a passive loss that will be carried over until you have passive income or you sell the property.

Adjusted gross income

Adjusted gross income is all of your various types of income added together, minus certain expenses (or “adjustments”). These include contributions to an IRA or Health Savings Account, self-employed health insurance and alimony paid, to name a few.

As you can see, when it comes to taxation, the definition of income isn’t really as simple as the dictionary suggests — and it can have a big impact on your tax bill.

This article also appears on Nasdaq.

Image via iStock.