As we mentioned before, income is taxed in one of four ways: active, passive, low-income tax brackets and center. But what if there was no difference in how to pay your taxes?
In that case, all incomes would be treated equally and therefore not mattered when it comes time to calculate how much you owe in taxes.
This will probably never happen at the federal level, but some states have introduced such a system. In those cases, there are two more categories: high-income tax bracket or zero-tax state.
The first type of person would likely spend most of their lives in the high-income tax bracket since they’d mostly be paying very large amounts of money in taxes. (Think millionaires and billionaires.)
But what about people who earn less than $50,000 per year? They’ll fall into the zero-tax state category because they’ll only be paying around $0 in annual taxes.
That’s definitely not right! We should at least make an effort to help our government function properly by paying our fair share of taxes.
Luckily for us, there are several strategies that can easily net you many extra dollars every month. One of these strategies isn’t even considered expensive unless you do it extremely well, which many savvy individuals do.
You can also save lots of money with this strategy, but only if you're smart about it.
What most people refer to as “taxes” are actually dues that we pay for using public services, like roads or schools. A simple example is when you drive your car on our streets, you are paying for my road use in terms of access to these roads, and I am paid through the fees you pay for me to use this space.
In similar fashion, what we refer to as “income taxes” are payments made by individuals who use certain goods and services, such as health care or education, which are provided to us by our community. These income taxes go towards funding those things that make our lives more productive, accessible and meaningful.
However, not all payments are considered income taxes. For instance, if you own a house, you may be asked to pay an annual property tax bill per your home ownership. This is not related to how much money you earn and it does not depend on whether you use the school system or not. It is simply a way for your municipality to maintain the well-being of their community.
Furthermore, some countries have a consumption tax (also called sales tax) where every product or service has an added cost due to the tax. This is typically placed onto the final item purchased but can sometimes apply at the source level. An example of this would be buying groceries – while food costs fluctuate seasonally, many states now add a general sales tax on everything sold.
Corporate income is all money that comes in from your business, or is earned while you are working to grow your business. This includes dividends, interest, royalties, capital gains, and more.
Many people consider passive investment sources like stocks, bonds, and real estate to be forms of taxable income. However, this isn’t necessarily true!
In fact, some experts believe that it is illegal to classify certain types of investments as taxable income. Others say that only high-income individuals must include these things in their taxes, not small businesses like yourself!
This article will talk about three specific ways that investing can’t easily be called taxable income. You’ll also learn how to use each one for an incredible tax savings strategy.
Capital gains are the difference between what you sell an investment for and how much you paid to purchase it. If your house is worth $500,000 but you sold it for only $400,000, that is a capital gain!
In order to determine if this is considered taxable income or not, we have to look at the definition of “income” and then see if the rules apply in tax laws.
Definition of income: Money received into one’s possession
Does buying and selling a house fit the bill? Absolutely! The money you receive when you sell anything is called income.
By law, every person must report their full yearly income (including capital gains) on their taxes. This includes dividends, interest, pensions, etc. So although it may feel like people with large capital gains get away with it, everyone’s situation is different – it really does depend on what kind of individual you are as well as what kind of tax bracket you fall under.
Taxes exist so that our government can spend enough money to give us all a good quality of life. By having these fees, they are able to fund things such as education for kids, medical treatments and equipment for those with health issues, and more transportation options.
Dividend income is defined as “income from the stock market or finance sector that comes in the form of periodic payments for your investment.” This includes capital gains (the profit you make when you sell an asset) and dividends (payment made by a company for owning their shares).
Dividends are typically paid out at the end of the year, when the money is collected back from shareholders. Some companies choose to distribute part of its earnings each quarter instead.
With the recent tax law changes, some high-dividend payers no longer qualify as passive income because they require active involvement in managing the firm. As such, these individuals may be taxed more heavily on their savings!
More expensive taxes can hinder your ability to invest in the future and grow your wealth. By investing early enough, you can avoid this situation completely.
Interest is defined as “the profit derived from investments” or “return on investment.” This typically includes dividends, capital gains, and royalty incomes. Some examples of pure-interest income are dividend payments and capital gain distributions.
But there’s a tricky word in that definition. It’s the word “profit.” Technically, anyone who earns money can call it a profit. By this standard, every millionaire out there is making a profit because they earn more than what they spent to live their lives. (And we all know how expensive living well can be! 😉 )
However, when talking about tax obligations, the term profit gets a little bit fuzzy. Because most people agree that earning a high salary is worthy of celebrating, many governments tend to classify any sort of pay increase as a profit for purposes of paying taxes.
This means that even if someone is spending the money they make investing on things like food, rent, and utilities, they may still have to report the investment return as taxable income.
What is tax-qualified as ‘rent’ in the United States varies slightly depending on who you are asking. For example, if you are talking to someone with very specific definitions for what constitutes rental income, it might make sense that they could question whether your passive income counts as taxable income.
However, most experts agree that monthly payments made use of property or business ownership is considered taxable income. This includes any additional fees related to owning or renting an apartment or house, as well as utilities paid while in residence.
Furthermore, many people consider investment dividends to be taxable income. These are earnings typically given to investors from their stock holdings by the company that owns the stock.
On top of all this, some countries classify certain gifts or donations received as taxable income. Many times these are things like books or clothes that you give away to help promote your career. Make sure to include these when calculating how much money you pay in taxes.
What is tax-exempt income? According to the IRS, it’s anything that does not result in a taxable profit. This includes things like shareholder dividends from your stock portfolio, interest you earn on your savings, or royalties you receive for your creative work.
By including this category in their definition, the IRS effectively gives themselves a blank check to classify almost any form of money as tax exempt.
Because they feel that investment returns are inherently moral (even if they aren’t!), many people refer to dividend and capital gains distributions as “dividend income” or “capital gain[s]”. This isn't entirely accurate, but it has helped shift the focus away from whether these types of incomes are morally okay to instead arguing about how much taxes need to be paid on them!
"Dividend income" is also frequently referred to as "retirement income." While this is technically correct, it can easily lead to confusion.
We will talk more about why in our article on the best ways to save for retirement. For now, just know that most experts agree that investing in stocks is one of the best ways to ensure a comfortable retirement.
As discussed earlier, you do not need to include every dollar of your active or passive income in your tax return. You can choose to only report the amounts that are greater than $500 per year. This is referred to as taxable income or gross income.
By including all sources of income in your taxes, it may be difficult to determine how much money you actually have at the end of the day!
Taxes depend heavily on what type of income you have as well as whether or not you qualify for certain deductions. For example, if you earn more than the average person, then you might be able to take itemized deductions such as medical expenses over twice the national average.
This would reduce your taxable income considerably. By doing this, your net income (what you keep after deducting costs) will also drop. The lower your net income, the smaller amount of tax you pay due to our nation’s complicated taxation system.