Money makes the world go round, but taxes? Well, they help keep the world running! Whether you’re earning a paycheck, selling handmade crafts online, or cashing in on investments, it’s important to know how different income sources are taxed. Let’s break it down in a simple, easy-to-digest way!
1. Earned Income (a.k.a. The Paycheck Money)
What It Is:
Earned income is money you make from actively working. This includes:
- Salaries & Wages (what you earn from a job)
- Bonuses & Commissions (extra earnings on top of your salary)
- Self-Employment & Freelance Income (if you work for yourself)
How It’s Taxed:
- Salary & Wages: Subject to federal and state income tax, plus Social Security and Medicare (FICA taxes). Your employer usually withholds these taxes for you.
- Self-Employed Income: You’re responsible for paying self-employment tax (which covers Social Security and Medicare) in addition to regular income taxes.
- Deductions & Credits: You might be able to reduce your taxable income with deductions like student loan interest or retirement contributions.
Example:
Sarah earns $50,000 per year as a graphic designer. Her employer withholds federal and state income taxes plus Social Security and Medicare. She also contributes to a 401(k), which reduces her taxable income.
2. Investment Income (a.k.a. The Money That Works for You)
What It Is:
Investment income comes from money you’ve invested, including:
- Dividends (payouts from stocks you own)
- Interest Income (from savings accounts, bonds, etc.)
- Capital Gains (profit from selling stocks, real estate, or other assets)
How It’s Taxed:
- Dividends: Qualified dividends get a lower tax rate, while ordinary dividends are taxed as regular income.
- Interest Income: Usually taxed at your ordinary income rate.
- Capital Gains: If you hold an asset for more than a year before selling, you get a lower tax rate (long-term capital gains). If you sell within a year, it’s taxed as ordinary income.
Example:
John buys 100 shares of stock for $1,000. A year later, he sells them for $1,500, making a $500 capital gain. Since he held the stock for more than a year, he pays the lower long-term capital gains tax rate.
3. Passive Income (a.k.a. The Money You Make While Sleeping)
What It Is:
- Rental Income (from properties you rent out)
- Royalties (from books, music, patents, etc.)
- Business Income (if you’re not actively involved in day-to-day operations)
How It’s Taxed:
- Rental Income: Taxable after deducting expenses like mortgage interest, property taxes, and maintenance costs.
- Royalties: Generally taxed as ordinary income.
- Business Income: If passive, it’s subject to regular income tax but may also qualify for special deductions.
Example:
Lisa owns a rental property and earns $18,000 per year in rent. After deducting $5,000 in expenses, she pays taxes on the remaining $13,000.
4. Retirement Income (a.k.a. Your Future Self’s Paycheck)
What It Is:
- Social Security Benefits
- Pension Income
- Withdrawals from Retirement Accounts (401(k), IRA, etc.)
How It’s Taxed:
- Social Security: May be partially taxed based on your total income.
- Pension & Traditional 401(k)/IRA Withdrawals: Taxed as ordinary income.
- Roth IRA Withdrawals: Tax-free if you meet the requirements.
Example:
Mike, a retiree, receives $30,000 from Social Security and a $20,000 pension. Since his total income is above a certain threshold, part of his Social Security is taxable.
5. Other Income Sources (a.k.a. The Miscellaneous Money)
What It Includes:
- Lottery & Gambling Winnings
- Alimony (depending on divorce date)
- Prizes & Awards
- Side Hustle Income (Uber, Etsy, etc.)
How It’s Taxed:
- Gambling Winnings & Prizes: Fully taxable, but you can deduct gambling losses if you itemize.
- Alimony: If the divorce was finalized before 2019, it’s taxable for the recipient. Otherwise, it’s not.
- Side Hustle Income: Treated like self-employment income, so you must pay both income and self-employment taxes.
Example:
Alex wins $5,000 in a poker tournament. He must report it as income and pay taxes on it, but he can deduct his gambling losses up to his winnings amount if he itemizes.
Final Thoughts: Keep More of Your Money!
Understanding how different income sources are taxed helps you plan better, reduce your tax burden, and avoid surprises come tax season. Keep good records, take advantage of deductions and credits, and consider consulting a tax professional for personalized advice!
Got any questions? Let’s chat in the comments!
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