What is income? Definition, examples, and the need-to-knows

Most financial journeys start with getting money to call your own. If you earn some money, you would call it income. There are many types of income and many ways you can acquire it. Understanding what income is can help you recognize the many opportunities to earn more of it. 

In this blog, we’re going to look at the income definition, go over some of the sources of income you could take advantage of, and talk about the tax implications of different types of income. (Keep in mind that it’s recommended to consult a financial advisor or tax professional to discuss your specific situation.) 

What is the income definition?

The definition of income is the money you receive for doing work, or for holding onto an asset or investment. Income can be from an active source, like when you have a job, have a side hustle, or run a business. The IRS classifies this as earned income. 

There are also passive income sources, which allow you to earn money without having to directly work for it. Passive income could be rental income, investment income, or pension distributions. The IRS calls this unearned income. 

This income definition seems straightforward, but there are other factors to consider when you want to calculate your own income. Personal income can be broken down further into gross income and net income. 

Gross income is the total income you earn before any expenses or taxes come out of your paycheck. For instance, if you get paid $10 an hour and work 20 hours per week, your weekly gross income would be $200. 

However, just because you earn a certain amount of gross income, it doesn’t mean you’ll see that in your paycheck. Net income is what you have left over after money comes out for taxes, insurance, and contributions to your retirement account. So, in that same scenario, if your gross income for the week was $200 but $50 was taken out for taxes and other deductions, your net income, or the amount of your paycheck, would be only $150. 

Similarly, if you are self-employed or have small business income, your gross income would be your revenue from selling your product or service minus the cost of goods sold. Your net income would be the profit you made after you paid your taxes and business expenses. 

Related to the income definition, you might also hear the term “discretionary income.” This is the amount of money you have left over to spend after you’ve paid all your bills and put aside money that you planned to save and invest. 

How is your income taxed?

If you make some money, you might owe taxes to the IRS. If it’s earned income, which means money you worked for, you’ll probably at least pay federal income taxes, Social Security taxes, and Medicare taxes. Depending on where you live, there could be some taxes from your city or state as well. 

Let’s take a look at how the IRS classifies income first.

Types of income

Beyond income definitions like passive and active income, which have to do with how you earn your money, it’s important to understand the tax implications of various kinds of income. The IRS has its own classifications for income. These are ordinary income, capital gains, and tax-exempt income. Let’s explore each of these. 

Ordinary income

Ordinary income is earnings, interest, stock dividends, rental income, pension or retirement account distributions, and Social Security benefits. Basically, if someone gives you money for working or owning something, it gets lumped into the ordinary income category. All of these earnings together will determine your tax bracket, or the maximum percentage of your income that you’ll owe to state and federal tax authorities. 

In 2023, the income tax rates for ordinary income range from 10% to 37%. 

Capital gains

Capital gains are profits you make from buying and selling assets like real estate, stocks, or collectibles. If you buy a share of stock for $100 and then sell it for $150, that $50 profit is considered your capital gains, and it’s what you could be taxed on by the IRS. 

The tax rate will depend on your income tax bracket, how long you’ve held the asset, and what the asset is. Assets held for less than a year are considered short-term gains and are treated like income. 

Assets held longer than one year are considered long-term gains and are taxed according to the capital gains rate, which can range from 0% to 28%. 

Tax-exempt income

Buying certain federal, state, and municipal bonds is like lending the government money and having them pay you back over a period of time with interest. In many cases, the interest you make from buying government bonds is exempt from some or all taxes. 

Just remember that the federal government and states have different rules about what is taxable and what isn’t. Be sure to check the tax rules on your investments before you buy in. 

Income tax deductions and exemptions

Before you worry about how much of your earned income you’ll be spending on your tax bill, let’s take a look at how you can pay fewer taxes and keep more of your money. With deductions and exemptions available, you probably won’t have to pay taxes on all of your ordinary income. 

Adjusted gross income

To encourage taxpayers to do things like save for retirement and put money aside for health care costs, the IRS allows us certain tax exemptions or advantages. These can be for adding some of your income to a medical savings account or a retirement account, for example. 

To show how this helps you, let’s say you made $30,000 in gross income, and you put $1,000 into a tax-exempt medical savings account. Your adjusted gross income would now be $29,000. This means you’ll be taxed on a smaller amount of money, which means you’ll pay less in taxes overall. 

Taxable income

To allow you to save some money, the tax law lets you deduct certain expenses. This means you’ll be able to lower the amount of money that you’ll be taxed on. If you own a business, you can deduct your business expenses so you only pay taxes on your profits. If you have a job, you can deduct some expenses you were required to pay in order to earn your wages. For instance, you might be able to deduct the cost of a work phone or the dry cleaning bill for your uniforms.  

There are even deductions you can make that have nothing to do with work, like any charitable donations you’ve made or interest you paid on some student loans. 

If you don’t have a lot of those expenses and still want to lower your tax bill, the IRS makes a standard deduction available to everyone. This is an amount of money you can deduct from your taxable income instead of taking some of the other deductions. In the 2023 tax year, the standard deduction for independent filers is $13,850. That means the first $13,850 you make at your job or business will not be taxed if you claim it. 

To go back to our past example, if you made $30,000 in 2023 and put $1,000 into a tax-free medical savings account, that would leave you with an adjusted gross income of $29,000. Then if you took the standard deduction of $13,850, your taxable income would now only be $15,150. 

Level up your financial literacy.

The basic income definition is an important piece of an overall understanding of your finances. Income is, simply put, the money you earn from your work, selling something for a profit, or holding onto a valuable asset. 

It’s also important to know about types of income, like passive income vs. active income, how your income is taxed, and how you can lower your taxable income to pay less in taxes. 

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