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Understanding Income and Its Tax Implications

Income refers to actual cash or assets received. For example, if John Doe earns a salary of $100,000 per year from Company XYZ, this is considered his income. However, inflation can reduce the real value of income over time. There are different types of income such as gross income, taxable income, and ordinary income that are treated differently for tax purposes. In the United States, income is taxed progressively through a series of tax brackets, with higher income subject to higher tax rates. Understanding how different types of income are taxed can impact investing decisions.

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15 views2 pages

Understanding Income and Its Tax Implications

Income refers to actual cash or assets received. For example, if John Doe earns a salary of $100,000 per year from Company XYZ, this is considered his income. However, inflation can reduce the real value of income over time. There are different types of income such as gross income, taxable income, and ordinary income that are treated differently for tax purposes. In the United States, income is taxed progressively through a series of tax brackets, with higher income subject to higher tax rates. Understanding how different types of income are taxed can impact investing decisions.

Uploaded by

Kumar
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Income

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What it is:
Income is an actual or recorded inflow of cash or other assets. The term is used in many
different contexts.

How it works/Example:
Let's say John Doe works for Company XYZ. His salary is $100,000 per year. This is his
income.
If the inflation rate is 3% per year, then the value of that $100,000 falls by 3% a year as
goods and services get more expensive. As a result, after the first year on the job, John's
salary is really only able to buy $100,000 (3% * $100,000) = $97,000 of goods and
services. In year two, John's salary is then only worth $97,000 (3% * $97,000) = $94,090.
The longer this goes on, the less John's $100,000 salary buys. By the end of five years, John's
salary would be "worth" only $85,873. His "real income" is $85,873.
Gross income is income before taxes or adjustments. In the accounting world, gross income is
usually the same thing as gross profit (that is, revenue minus cost of goods sold). So let's
assume restaurant chain XYZ sold $1 million worth of food last year. The cost of that food
was $330,000. Thus, the company's gross income was $1,000,000 - $330,000 = $670,000.
For individuals, gross income is not the same as taxable income. For example, if John makes
$1,000 a week and uses $250 of that to invest in his 401(k) plan, his gross income would be
$1,000 but his taxable income would be $750.
Ordinary income is income that is not a capital gain, dividend or other income subject to
special taxation.
In the United States, income is taxed progressively, meaning that there are a series of brackets
in which income is taxed. For example, in 2006, the first $7,550 of ordinary income reported
by a single person was taxed at 10%; then the income over $7,550 but below $30,650 was
taxed at 15%. The income over $30,650 but below $74,200 was taxed at 25%; the income
over $74,200 but below $154,800 was taxed at 28%; and the income over $154,800 but
below $336,550 was taxed at 33%. Any income over $336,550 was taxed at 35%.

Why it Matters:
Wages are the most common kinds of income. "Unearned income," such as capital gains, is
taxed at different rates, as are dividends. Interest income is sometimes exempt from ordinary
income taxes (as in the case of most municipal bond investments). Dividends paid to the
shareholders of a company are another kind of income, and those investors might even rely

on those dividend payments for their day-to-day living expenses. Dividends usually come in
the form of cash, but they can come in the form of stock, which can also be regarded as
income for tax purposes.
Knowing how taxes on income affect one's portfolio can make a big difference in investing
decisions. For example, one big advantage to owning dividend stocks is their generally
favorable tax treatment. Until 2003, dividends were taxed as ordinary income -- up to 38.6%
-- and capital gains were taxed at a much lower 20%. In 2003, the tax on most dividend
income and some capital gains fell to 15%. Not only did this encourage companies to
increase dividends, it encouraged stock ownership because interest income from Treasuries
and money market funds were still taxed as ordinary income.

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