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Your 3 Types of Taxed Income

  • 27 August 2019
  • Author: Cari Holbrook
  • Number of views: 263
  • 0 Comments
Your 3 Types of Taxed Income

Taxes are fickle. One classification misunderstanding and the IRS could blindside you with a tax or a tax rate you weren’t expecting. Small business owners are especially vulnerable since their personal and business assets can be uncomfortably intertwined. The key to tax savings is in understanding three main types of taxed income and how the money you make (or lose) should be classified. 


Earned Income

This is the main source of income for most people. It’s the income you actively earn by working for yourself or for someone else. Wages, salaries, tips, and other taxable employee pay and self-employment net earnings make up the bulk of this category. 


Earned income is subject to two types of taxes: employment taxes and ordinary income taxes. Employment taxes include Social Security and Medicare taxes (collectively called FICA taxes) and workers compensation fees (when applicable). Ordinary income taxes include both state and federal taxes (although some states like Texas do not levy an income tax). 


Ordinary income is subject to the much-debated marginal tax brackets. These tax brackets determine how much federal income tax you need to pay at certain levels of your income. For the 2019 tax year, the marginal tax brackets range from 10% for incomes of $9,700 or less ($19,400 for married couples filing jointly) up to 37% for individual single taxpayers with incomes greater than $510,300 ($612,350 for married couples filing jointly). Once you reach a certain income threshold with your ordinary income, you can be subject to an additional Medicare tax, an Alternative Minimum Tax (AMT), and other tax expenses.


Other forms of income that originate or are tied to earned income are subject to marginal income tax rates as well, including union strike benefits, some long-term disability benefits, pensions, 401(k) and traditional IRA distributions, and even alimony. 



Investment Income

Also called portfolio income, investment income is money that is made by selling an investment for more than what was paid. Most stocks, bonds, mutual funds, and some real estate fall into this category. 


If an investment asset is held for one year or longer before it’s sold, it will be classified as a long-term capital gain for tax purposes. This is important because most long-term capital gains are taxed at a 15% rate or less. High-income taxpayers pay more, but still not as much as their marginal tax rate. Those making $425,899 for single and $479,000 for married filing jointly will be taxed at $20% plus Net Investment Income Tax (NIIT), if applicable. Capital gains from selling unrecaptured section 1250 real property or collectibles like coins or art are also taxed at higher rates


Passive Income

The IRS defines this area as any rental activity or any business in which the taxpayer does not materially participate. Examples can include equipment leasing, rental real estate, and limited partnerships. Dividend income received from Real Estate Investment Trusts (REITs) may also qualify, as might income from selling intellectual property like books, but those areas are very murky


Income generated in this way is usually taxed at ordinary income rates, which means they’re subject to the marginal tax brackets and related tax rules. 


Special Considerations for Business Owners

Business owners are often hit with each of these three taxes. How you classify your business—whether it’s a corporation or pass-through entity, for instance—plays a big role in how you’ll be taxed on business income and investments. It also plays a role in how you can take advantages of business deductions and losses. 


Many business owners don’t have difficulties until they face a year of extremes: big gains, huge losses, or the sale of their business. It’s at those points—usually when it’s too late—when clarity kicks in. Any tax changes or changes to your business can poke holes in a previously water-tight plan as well, so plan ahead and reevaluate often. Feel free to contact us with questions.  


Photo via 123rf.com 


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