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Income and tax go hand in hand every year

Posted: March 6, 2013 - 1:15am

Income. Income Tax. See how these two words just run together. Can’t say one without the other. Can you? But what exactly is income? Looking at the Oxford English dictionary it is stated as “money received from work or investments.” That was simple wasn’t it? But in the lexicon of the IRS there are many types of income and subcategories. Gross Income, Adjusted Gross Income, Earned Income, Passive Income, Taxable Income. And they all fall into TWO sections: Ordinary Income and Capital income.

Take for instance, ordinary income. The IRS defines it as income other than capital gains. They also say all income earned worldwide is taxable for US filings. Since the tax system is progressive, the more you earn the more you pay and can be as near to 40 percent of taxable income and obviously can be as low as zero percent. However, when it comes to capital gains the new rate can be locked in at a maximum of 20 percent which is the result of holding an asset for over a year and then selling it for a profit. As you can see the tax on this type of income is at a lower rate than ordinary income and is more desirable.

Ordinary income represents wages, salaries, dividends, interest, business income, alimony, rents, and earnings from partnerships, royalties, pensions and annuities and even distributions from trusts. Even though Social Security payments are taxable in certain instances, they are not generally recognized as ordinary income.

To drop down lower in the income categories, there are two other classifications to understand. Earned income and passive income. Earned income is exactly what is says, you actually have to earn it the old fashioned way; by working for it. So if you are paid for personal services, then you have received earned income. One of the more attractive credits that are available is the earned income credit. As its name implies, if you do not have earned income, you are not eligible for the credit.

Passive income generally relates to income not actually received from services performed. It is also known as income that is “earned while you sleep.” An easy way to remember is to use the word rapids as a guide. Rents, annuities, pensions, interest, dividends and sale of an asset are the key elements. Most ordinary income can be determined by W-2’s, or 1099’s or other documents received from third parties such as banks, pension administrators, mutual funds, etc.

It is easy to see what the income is from these various elements but when it comes to someone who is self-employed, what is “income”? It can’t be all receipts collected, as there would be no allowance for the ordinary business expenses such as purchases, auto expenses, insurance, rent, utilities and others too numerous to mention. The result of these reductions will then be allowed to be included in what the IRS will classify as gross income. Certain allowable expenses such as teacher’s costs, IRA contributions, alimony paid to a former spouse and a few others, create what is then known as adjusted gross income. Itemized deductions and personal exemptions further reduce the adjusted gross income to what is then called taxable income. Eventually the income tax is based on this figure and after other credits; the net amount is either due or refundable.

Observation: Home is where you are loved even by those who know all about you.


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