Understanding Different Types of Income
Several years ago, Warren Buffet famously declared that he pays a lower percentage tax rate than his secretary. Many felt this was an injustice. Politicians were quick to jump on the bandwagon and introduce the Buffett Rule, which would ensure individuals making more than $1M in income pay no less than 30% in tax.
Rather than get upset by this injustice, we should investigate how one of the richest men in the world pays a lower percentage tax than his secretary. The answer is simple. Since the majority of Buffet’s income is derived from investments, he pays a lower tax rate than his secretary since her income, presumably, comes from earned income.
For those of us seeking financial independence, the fact that the IRS gives preferred treatment to investment income is good news. We strive to be like Buffet and have more of our income derived from investment income than earned income.
Investment income is good for companies, it’s good for individual investors and it’s good for the economy overall. And, of course, it’s good for the tax rate.
To understand the difference in tax rates, it’s important to understand the differences in the 3 types of income: earned income, investment income and passive income.
Earned income is the money earned from working for someone (or a business) or income received from running your own business. According to the IRS, earned income includes: wages, salaries, tips, and other taxable employee pay; union strike benefits; long-term disability benefits and net earnings from self-employment.
Earned income is taxed at the highest rate of the 3 types of income.
And once you stop working, the earned income also stops.
Currently, there are 7 Federal income tax brackets for earned income. The brackets are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The amount of Federal tax paid depends on income level, filing status and applicable deductions and credits.
Earned income is also subject to FICA (Federal Insurance Contributions Act,) which includes Social Security and Medicare, and any applicable state and local taxes.
Investment income (or portfolio income) is money made on investments including interest, dividends and capital gains or selling real estate or other assets.
While certain types of investment income are taxed as ordinary income, dividends and capital gains receive preferential tax treatment. Qualifying dividends and long-term capital gains are taxed from 15% to 20%.
Investment income is not subject to FICA. Capital losses can also be used to offset any income from capital gains. Proceeds from the sale of property also receive preferential tax treatment.
From a tax perspective, it’s clear why investment income is preferred over earned income.
Passive Income is income received while not actively engaged in its generation. The IRS defines passive income as being generated though rental activity and investments in companies in which there is no hands-on activity.
Passive income receives very favorable tax treatment from the IRS. Anyone who has owned rental property recognizes the importance of depreciation alone.
Transitioning from Earned Income to Passive and Investment Income
Early in our careers, my husband and I relied solely on earned income. However, we are now focused on growing our passive and investment income streams. The goal is to increase passive and investment income to compensate for the loss of earned income.
Currently, we are actively adding to our investments in peer to peer lending and dividend stocks.
While very few of us (or none of us) will ever have the investment income of Warren Buffet, we can still strive to be in his tax bracket. And not in his secretary’s.