When I was a kid, I thought income was income was income. If you get paid for something, it's “income.”
It wasn't until I got older that I started learning that there are different types of income; with each getting its own special tax treatment. It's important to understand this because it can impact how much of that income you get to keep.
The three major types of income are:
- Earned income
- Passive income
- Capital gains
Earned and passive income are both taxed as ordinary income but earned income is also subject to FICA taxes. Capital gains can be taxed either as ordinary income or as long term capital gains depending on how long you held the asset. If you owned the asset for over a year the appreciation is taxed at a lower rate.
First off, let's set the stage for a number that's important but rarely used – your gross income.
Your gross income is all the income you earned or received in a year.
Think about your W-2 income from your job. Let's say your salary is $50,000 a year, but your paychecks don't actually equal $50,000 because you have a lot of deductions. You might be contributing to your 401(k), paying for health insurance, and paying taxes.
Your actual paychecks are quite a bit less than your salary of $50,000.
Yet, in this case, $50,000 is your gross income. What you actually receive is your “net income”.
For tax purposes, your annual gross income includes your wages from your job but also bank interest, dividends from investments, capital gains, rental income, etc. If it was paid out to you, it's gross income.
As a kid, when I thought income was income, I was thinking of gross income. Fortunately, gross income is rarely used for tax purposes. They use a different measure, adjusted gross income.
Adjusted Gross Income
A sub-category of gross income is Adjusted Gross Income, or AGI. Your AGI is your gross income minus a series of deductions that the tax code has chosen. These include items like retirement contributions, such as to a 401(k), healthcare savings account contributions, alimony, moving expenses, education expenses, etc.
Deductions lower your taxable income.
Adjusted Gross Income follows the same line of thinking as figuring the net pay of your paycheck. You start out with your Gross Income and then start subtracting things to find your AGI. The things you can subtract are your deductions.
Going back to our example from above, if you put $10,000 into your 401(k) then your Gross Income is $50,000 but your AGI is now $40,000 since contributions to a 401(k) are deductible.
If you're looking at a Form 1040 (2019), it is on Line 8b.
Earned income is the money you earn from doing work. You could be a full-time employee at a company with your earnings reported on a Form W-2. You could be a contractor working at a company through an agency or independently with your earnings reported on a Form 1099.
The important point is that you are paid for work that you are actively doing. If you didn't show up or didn't produce the work product, then you wouldn't have gotten paid. That's earned income.
Earned income is taxed by the federal government at ordinary income rates. This is determined by your tax bracket. Here are the current tax brackets if you want to see where you fall.
On top of income taxes, you'll also have to pay FICA – which stands for the Federal Insurance Contributions Act and refers to Social Security and Medicare. In total, you pay 12.4% for Social Security and 2.9% for Medicare. If you are self-employed you pay this entire amount. If you are a W-2 employee you'll only pay half and your employer covers the other half for you.
Note: you only pay Social Security on wages below the Social Security Wage Base ($137,700 for 2020).
Earned income is taxed at the highest possible rates because of the combination of ordinary income rates plus the FICA contributions.
But within the context of taxes, it has a very specific meaning because passive income is not subject to the FICA tax. The IRS has two groupings for what it considers passive:
- Real estate rentals – rental of property or equipment
- Businesses – where you do not “materially participate on a regular, continuous, and substantial basis”
Some businesses may involve real estate but the point is that you made an investment, you don't “materially participate” in the business, and you simply get a distribution check.
When you get paid from a passive activity, you will pay income taxes on that income but won't be responsible for FICA.
If you have a savings account, you earn interest from your savings in that account. If you participated in a new account bank bonus (where you are paid hundreds of dollars to open an account with a bank), that money is reported as interest. That's “passive” even though you did something to open the account.
A prime example of this is when I made an investment in a farm on AcreTrader. It's a corn and soybean farm in Illinois with a projected net annual return of 9.2% (4.3% cash yield) and the structure is that I'm a limited partner in a company that owns just that farm. I do not materially participate in the business (I don't do anything) and distributions are taxed at my ordinary income rates.
A common form of passive income is dividends. For tax purposes, there are two kinds of dividends – ordinary and qualified.
Ordinary dividends are taxed as ordinary income, while qualified dividends are taxed as long term capital gains (explained below).
Most of the dividends you will receive will be qualified. Qualified dividends meet certain IRS rules such as that the dividend was paid by a US or a qualifying foreign company. A few notable exceptions to this rule are master limited partnerships and REITS.
The IRS also requires you to hold shares of a stock for at least 60 days during the 121 days around a dividend payout date. If you don't, then otherwise qualified dividends are treated as ordinary dividends.
Capital gains are when you sell assets that have appreciated, such as stock or real estate. You will pay taxes on the appreciation – not the sale price.
The tax rate you are charged depends on how long you've held the asset before you sold it. If you held the asset for less than a year, you pay short term capital gains rates. If you hold the asset for over a year, you pay long term capital gains rates.
Short Term Capital Gains
Short term capital gains rates are charged if you hold the asset for less than a year. The appreciation of the asset is taxed at the same rate as your earned income. You do not have to pay FICA taxes, only income taxes.
For example, if you buy a stock on January 1st for $100 and sell it on November 1st for $150 you will owe income taxes on the $50 you made from this transaction. If you are in the 22% tax bracket then you will owe $11.
Long Term Capital Gains
Long term capital gains are charged if you hold the asset for over a year. In this case, the appreciation is taxed at long term capital gains rates, rather than at your ordinary income tax rate.
Long term capital gains rates are 0%, 15%, or 20% depending on your income. Here are the income levels for married filing jointly.
- 0% if your income is less than $80,000
- 15% if your income is between $80,001 and $496,600
- 20% if your income is over $496,600
Additionally, there is a net investment income tax (NIIT) of 3.8% if your income is over a certain amount:
- Single filers – $200,000
- Married filing jointly – $250,000
- Married filing separately – $125,000
There are many types of income and each income source has its own tax rules. Earned income is the most heavily taxed as it's taxed at ordinary income tax rates and is subject to FICA taxes. Passive income is taxed as ordinary income but is not subject to FICA taxes.
Finally, capital gains can be taxed at either ordinary income or at the more favorable long term capital gains rates, depending on how long you held the asset.