Many of you probably have heard that to make a good wage you have to go to school, get good grades, graduate, and work for a company. Sounds pretty straightforward and I, too, was taught this from an early start. We graduate from high school, college, masters, or doctorate, and once education is completed, you head out to the working world to use your educational knowledge to earn an income. There are essentially 3 types of income sources: Earned Income, Investment Income, and Business Income.
Exactly what most of us are probably accustomed to. Get a job and work for someone or a company. Then get a pay check. After all the taxes and deductions are taken out, you’re left with your take home pay. Depending on your taxable income, federal taxes are applied at certain tax rates. The key point I want to make is that federal and other taxes are taken out from your wages first. Whatever is leftover, is yours to take home. I’ve been working over 20+ years and how many times have I actually looked at my wage summary. Only a handful of times! Once I figured out all the taxes Uncle Sam takes out, it’s amazing how much that is left and what your take home pay is.
Investment income is income you receive from investments like stocks, bonds, and real estate which is also taxed but in different percentages not the same as earned income. This can get complicated but the point I want to make is that investment income is taxed at either 0%, 15%, or 20%. Not knowing much about taxes and tax laws, I had the assumption that any income I made was considered income and federal taxes are applied at the tax rate I’m currently in. Don’t get this mixed up with interest income such as interest you get from a savings account. Interest is normally taxed the same rate as your federal tax rate.
Business income is income earned from a business you own. If you are a small business, your business tax rate could be lower. Small businesses in the United States pay an estimated average effective tax rate of approximately 19.8 percent according to the Small Business Administration. One point I want to make is that taxes are applied after all expenses are factored. Let’s say your business made $100,000 but you had $50,000 worth of expenses. Your business won’t pay taxes on $100,000, rather on the $50,000. I experienced this first hand with my real estate business income. Although I receive monthly payments from my renter and that is considered business income, I do have expenses that I had to pay for maintenance, property taxes, mortgage interest, and so on. The rental income minus the expenses is my business income that will be taxed. And with the average of 19.8% tax rate, it’s better than the 22%, 24%, or higher tax rate if it was earned income.
Another thing is I’ll be monitoring closely on my business income and investment income especially when we file taxes. I’ve always filed Married filing jointly just because and I always wondered why people would file Married filing separately. Because of tax reasons! If you and your spouse are in different tax brackets versus filing jointly at the higher tax bracket, it might make sense for you to file separately. This is something I plan to consider doing this year. As always, consult with a professional before making any decisions.
Out of the three income sources, unless you’re in the 10% or 12% tax bracket, earned income is not the most economical when you factor in how much taxes you have to pay. I’ve been a 9-5 worker all my life but I’ve been involved in stocks and real estate. I didn’t dig deep into the numbers until recently and understanding the different income sources and how each are taxed differently. My assumption was that any income that I had was taxed at the same earned income tax rate I am in but that isn’t the case.
Earned income is likely what you’re most familiar with. Interview for a job, start working, and get a pay check. Earned income is what we are accustomed to but keep in mind it’s heavily taxed than the other two. Business and investment income requires work upfront to even make a penny. What’s more appealing? Earned income at a higher tax rate or try to build business and investment income which typically gets taxed lower? After earning income from all three sources, I’m going to focus on the business and investment income side more. If you are interested in following my journey, email subscribe to get alerts of latest posts or follow me on Facebook.