Growing up you’re expected to go to school, get a job, and get paid income for the work. But what exactly is income? How many different types of income are there and what’s the difference?
If you’ve never stopped to think about the various forms of income, keep reading.
What is it?
Everyone knows what income is, although it’s not always easy to explain. Money, gain, or anything of value that you receive from whatever source generally is included in income.
When the topic is income, however, there are a number of concepts and terms that may be completely unfamiliar to you. Some are very broad and are beyond the scope of tax planning, while some pertain to very specific areas of tax law.
The purpose of this discussion is to familiarize you with some of the more common concepts involving income.
“Taxable” vs. “nontaxable” income
Generally, income is taxable unless specifically exempted by law. Income that is taxable (e.g., wages) must be reported on your tax return and is subject to tax. Income that is generally not taxable (e.g., interest on tax-exempt municipal bonds) may have to be shown on your tax return, but is typically not subject to tax.
The term “subject to tax” is really a simple way of saying that the income is included in your “adjusted gross income.”
Earned vs. unearned income
The distinction between earned income and unearned income is important–it comes into play in a number of situations.
For example, the amount that you can contribute to an IRA depends, in part, on your earned income for the year (actually, it depends on your “compensation,” but for the most part, compensation is earned income).
As its name might imply, the amount of earned income credit (EIC), as well as the child and dependent care tax credit, that you may be entitled to also depends on your earned income. Also, when dealing with the income of a child, there is an important distinction between earned and unearned income, and the kiddie tax rules may apply.
So, what is earned income? In general, earned income includes salaries, wages, tips, professional fees, and other amounts that you receive as compensation for work that you perform. This would include income from self-employment. What isn’t earned income? Usually, everything that falls outside of that definition.
Caution: The exact definition of earned income depends on the specific tax rule or credit. For example, there is a specific definition of earned income for the purpose of claiming the earned income credit.
Realizing and recognizing income
When someone talks about a person realizing income or loss, it means that person’s dollar worth has changed in a measurable way and that the resulting change has some tax significance. Usually the term comes up in discussing property, assets, or securities.
For example, if you buy a share of stock for $1 and 10 years later you still have that share of stock, only now it’s worth $10, your dollar worth has increased by $9.
Have you realized income? No. If you realized income just because the stock increased in value, you would realize income and loss virtually every time that the market changed, no matter how slightly.
You haven’t realized income on the stock because no “realizing event” has occurred. If you sell the stock for $10, however, you realize $9 in gain.
Saying that income is recognized means that it is included in your gross income. All income that is realized is recognized unless a specific Internal Revenue Code (IRC) section provides that it is not recognized.
For example, if you exchange like-kind property, you may realize gain or loss, but, if certain requirements are met, IRC Section 1031 provides that such gain or loss is not recognized.
You may have to recognize income even though you don’t physically receive it. You constructively receive income when it is credited to your account or made available to you. In other words, you do not need to have physical possession of it.
For example, if you receive interest, dividends, or other earnings on any deposit or account in a bank, savings and loan or similar financial institution, or receive interest on life insurance policy dividends left to accumulate, then you are treated as constructively receiving income on the deposit or account even if there are certain restrictions that make it inconvenient to withdraw the income (e.g., having to withdraw the entire balance or paying penalties).
Selling property and assets
Special rules apply when you sell property and assets. You’ve probably heard something about capital gain income, but the rules regarding the sale or exchange of property involve more than just capital gain. If you sell business assets, a number of different Internal Revenue Code sections can apply.
Income in respect of a decedent
Income in respect of a decedent is gross income a deceased individual would have received had he or she not died that has not been included on the deceased individual’s final income tax return. If you receive such income, you may have to pay the income taxes on it.
There are actually occasions when you might have to pay tax on income that you never actually receive. This is called “phantom” income and can arise in numerous situations, including when partnership income is not distributed or when loan transactions take place between family members.
Now that you know the difference between the various kinds of income, take the time to connect with an advisor and/or a CPA to ensure you’re making the most of all of your income.