Did you know that different types of Income have different taxes?
Income is what you receive when you provide value to another individual or group of individuals by providing goods, services, or capital. Income can come in the form of salary or wages for workers. For retirees, it could come in the form of pensions, investments, or social security. Investors also earn income in terms of return on investment. The government will require you to pay tax on most forms of income.
When we think of taxes, there is a significant difference between different types of income. In other words, different types of income have diverse tax implications. Thus, this article will discuss the types of income that exist, and each’s tax implication.
Let’s get into it.
Active or Earned Income
This is the class of income that most people refer to when they talk about income. It includes wages, salaries, tips, and bonuses. Payment received for providing goods or services as an independent contractor is not exempted from active income.
Although many people don’t consider themselves to have earned income because they are self-employed, the fact is that money made from self-employment is also subject to taxation, especially if you actively participate in the business. For instance, the profit that flows to your tax return as a shareholder in a corporation is not subject to taxation. However, the income you make as a sole-proprietor or a general partner in a partnership is subject to taxation.
Pensions, traditional IRAs, distributions from 401(k)s, and some other forms of retirement income, as well as alimony that you receive, also belong to the active income category and are subject to taxation. Even though you do not directly earn these incomes, they emanate from an individual’s earned income (whether yours or another person’s), and they are subject to taxation.
The government expects you to pay tax on your earned income according to the marginal tax bracket shown in the table below.
Tax Brackets for Single Filers and Married Couples Filing Jointly for Year 2020
|Tax Rate||Taxable Income (Single)||Taxable Income (Married Filing Jointly)|
|10%||Up to $9,875||Up to $19,750|
|12%||$9,876 to $40,125||$19752 to $80,250|
|22%||$40,126 to $85,525||$80,251 to $171,050|
|24%||$85,526 to $163,300||$171,051 to $326,600|
|32%||$163,301 to $207,350||$326,601 to $414,700|
|35%||$207,351 to $518,400||$414,701 to $622,050|
|37%||Over $518,400||Over $622,050|
How does the marginal tax brackets work?
If you’re single, for instance, and your total taxable income for 2020 is $100,000. According to the table, it’s in the 24% bracket. So, does this mean that you will just pay 24% of $100,000? No! The marginal tax bracket’s idea is that part of the income will be taxed in the preceding rates. In this case, your tax will be as calculated below.
10% of the first $9,875 = $987.5
12% of the amount above $9,875, but less than $40,125 = $3,629.88
22% of the amount above $40,125, but less than $85,525 = $9,988
24% of the $14,475 that is in excess of the $85,525 = $3,474
Therefore, your tax will be $18,079.38, rather than $24,000 which would have been the amount if it was a flat rate.
There are three main classes of investment income – interest, capital gains, and dividend. These three are taxed differently. Let’s consider them in detail.
This includes income from interest on money loaned to others, savings account, CDs, and some bonds. However, the municipal bond interest is exempt from federal tax. You pay tax on interest income as you do to active or earned income.
This includes income from a capital investment like stock, commodities, real estate, digital currency, and mutual funds. Generally, you make a capital gain when you sell an asset for higher than the amount you purchased it.
Capital gains can either be short-term or long-term. If you hold an asset for less than a year, the profit you make while selling that asset is short-term capital gain. However, if you hold an asset for more than a year before selling it, the profit made is referred to as long-term capital gain.
The tax you pay on short-term capital gain is similar to the tax you pay on your active income. Long-term capital gains are taxed at lower rates of 0% or 15% for most people, and 20% for individuals with higher incomes.
This is the portion of a company’s profit given to its shareholders. There are two classes of dividends – ordinary and qualified. The tax you pay on the ordinary dividend is similar to the tax you pay on your active income. For qualified dividends, you pay tax at lower rates similar to long-term capital gains.
The requirement for a dividend to be qualified is that a U.S. company must pay it, and the investor must have held the stock for an extended period. The two significant exceptions to the qualified dividend criteria are limited partnerships and real estate investment trusts.
Passive investments yield passive income. Income from a business you invest in but don’t play an active role, and rental income is passive income. Also, income from real estate investment trusts, investment in actual properties, and some types of tax-sheltered investment options are passive incomes.
The tax rates of most passive income are similar to that of active incomes. However, you must know that there is a provision of a big tax break for passive income. You should consult a tax professional to determine your eligibility.
We are sure you have been enlightened on different income types and how they are taxed in this blog post. We didn’t even touch on payroll, excise, property nor estate taxes…Now that you know that there are different taxes for different types of income, reach out if you have any questions!
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