Learn Why You Must Have Working Knowledge of the Various Types of Income
Over the years we have found that consumers are often confused by the different types of income that they hear or read about.
In this discussion we will attempt to remove the confusion that you may have about the various types of income that you may hear or read about on a consistent basis.
Active Income is Earned Income. When you perform a service for payment in the form of salary, wages, commissions, or tips, you’re earning active income. Also if you actively manage rental real estate you would have active income that could be advantageous to you from a tax perspective.
Adjusted Gross Income
Adjusted Gross Income or (AGI) as it is often called is used in the United States (and other Countries) on individual income tax returns and it represents the total gross income that you earn for the year—minus certain deductions.
Taxable Income is adjusted gross income less allowances for personal exemptions and itemized deductions.
Taxable Income will be explained in greater detail later in this discussion.
For most consumers who file a U.S. individual tax return AGI is more relevant than gross income.
Gross income is income that you receive from all sources and include—sales price of goods or property, less cost of the property sold, plus other income.
Gross Income includes wages, interest, dividends, business income, rental income, and all other types of income that you may receive.
Contrast with Adjusted Gross Income which is income that you receive for the year—less deductions.
Several deductions (e.g. medical expenses and miscellaneous itemized deductions) are limited based on a percentage of AGI.
Certain phase outs, including those of lower tax rates and itemized deductions, are based on levels of AGI.
Many states base state income tax on AGI with certain deductions, therefore you want to select a tax professional who understands this—and can use that understanding for your greater benefit.
The amount of money that you have left over after all federal, state and withholding taxes have been deducted from your taxable income equals your after-tax income.
After-tax income represents the amount of "disposable income" that you have to spend on future investments or on current consumption.
After-Tax Income is often called “income after taxes” or disposable income.
When analyzing or forecasting your personal cash flows (or budget and personal income statement), it is important to use an estimated after-tax net cash flow or your disposable income so that you can get a real feel of where you are financially.
This is a more appropriate measure because your after-tax cash flows are what you actually have available for consumption.
This is not to say that all of your investments are purchased with after tax income—some companies offer salary deferral retirement plans that deduct money on a pre-tax basis (401ks, Thrift Plans, 403bs etcetera).
The money invested on a "pre-tax basis" would not be taxed immediately (benefit to you) but instead would be taxed once you decided to withdraw the funds (such as during your retirement years).
However, because most people have less income during their retirement years compared to their prime earning years, the amount of your tax paid would normally be less.
Discretionary Income is the money that you would have remaining after all of your bills are paid off on a monthly or yearly basis.
It is income after subtracting taxes and your normal expenses.
Your monthly expenses such as rent or mortgage, utilities, insurance, medical, transportation, property maintenance, child support, inflation, food and other miscellaneous monthly expenses that you pay to maintain a certain standard of living that you desire for yourself and your family would all be paid from your disposable income—and what would be left over is your discretionary income.
To derive your discretionary income you would take your gross income and subtract your taxes and necessities on a monthly or annual basis.
"Disposable Income" is often incorrectly used to denote discretionary income—therefore, it is important that you are able to distinguish between the two in your mind.
The meaning and your understanding of disposable income and discretionary income should be interpreted from the context in which it is spoken or written.
"Disposable Income" is the amount of money you have left after the payment of your "taxes"—left to spend or save.
When applying for a loan (mortgage, consumer loan), lenders may take into consideration your discretionary income in order to assess your loan repayment capacity.
In some cases potential borrower's may have a lot of income, such that the percent of available income may be smaller than normal standards would allow, but the actual amount of money is still large and would support a loan that the borrower is requesting.
Always distinguish in your mind that "discretionary income" is the amount of your income that is left for spending, investing or saving after your "taxes and personal necessities" (such as food, shelter, and clothing) have been paid.
It is money that "you" have "discretion over" as to how you want to utilize it (spend or save)!
Discretionary income includes money spent on luxury items, vacations, savings and non-essential goods and services.
Discretionary Income is “derived from” disposable income, which equals gross income minus taxes.
The total discretionary income levels for an economy will fluctuate over time, typically in line with business cycle activity—and "discretionary income" on an individual or family basis will also fluctuate over time based on household income and expense changes.
When economic output is strong (as measured by GDP or other market indicators), discretionary income levels tend to be high as well.
Or another way of looking at it is when the economy is booming discretionary income will to be higher.
On an individual basis if you were to get a raise at your job, cut expenses or work a secondary job—your "discretionary income" would increase.
If inflation occurs in the price of life's necessities, then your discretionary income will fall, assuming that your wages, your expenses and your taxes remain constant or relatively constant.
Discretionary spending is an important part of a healthy economy. People will only spend money on things like travel, movies and consumer electronics if they have the funds to do so.
Some people will use credit cards to purchase discretionary goods, but increasing personal debt is not the same as having discretionary income—and can be a dangerous strategy as it is possible that you could run your credit balance up to a level where it would be difficult or impossible to repay in a manner that made good financial sense.
It is important that you distinguish in your mind that Disposable Income is money that you have left after paying your taxes—while discretionary income is money that you have left over after paying your taxes “and” mortgage/rent, food, utilities, and life's other necessities.
Disposable Income is the amount of money that you and/or your household have available for spending and saving after income taxes have been accounted for.
Disposable Personal Income is often monitored as one of the many key economic indicators used to gauge the overall state of the economy and it is calculated as follows:
Disposable Personal Income versus Discretionary Personal Income
If you earn $100,000 and were in the 28% tax bracket your "disposable income" would be $72,000 on an annual basis.
Let’s say you have yearly household expenses of $40,000—your “discretionary income” would be $32,000 on an annual basis.
On a monthly basis your disposable and discretionary income would be as follows:
On a monthly basis your earnings would be $8,333 and your taxes would be $2,333—leaving you with disposable income of $6,000.
With monthly expenses of $3,333 per month your discretionary income ($8,333 minus $2,333 minus $3,333) would be $2,667 on a monthly basis.
Be sure to understand the two examples above as by doing so you will be in position to understand disposable and discretionary income in clear terms!
In 2005, the average disposable personal income dipped into negative territory for the first time since 1933.
This means that in 2005, Americans were spending
their entire DPI or Disposable Personal Income—and then tapping into debt for
Do your best to avoid that scenario in your and your family’s credit and financial life!
Gross Income is your total personal income before taking taxes or deductions into account.
Your gross income is how much you make before taxes. Gross Income is the figure people are looking for when they ask you how much you gross a month.
Gross Income is an important number when analyzing your personal finances, it indicates how you could more effectively plan your and your family’s credit and financial future.
Keep in mind that gross income varies widely from individual to individual.
You must always remember that “Gross Income” is all of your income from taxable sources, before subtracting any adjustments, deductions or exemptions.
Be able to contrast that with Net Income which is your income after subtracting any adjustments,
deductions or exemptions.
Investment or Portfolio Income
You must know that investment income includes income that you earn from savings and checking accounts, dividends from stock purchases and ETFs, Mutual Funds and other market investments that are in many cases taxable.
If inside of your retirement account or otherwise excepted from taxation the income would generally be taxable.
Modified Adjusted Gross Income
Certain tax calculations are based on modified versions of AGI.
The definition of Modified Adjusted Gross Income (MAGI) varies according to the purpose for which it is used.
These modified versions may add certain items to AGI that were excluded in computing gross income. Common additions include tax exempt interest and the excluded portion of Social Security benefits.
Modified Adjusted Gross Income or MAGI is often used when calculating the alternative minimum tax (AMT).
Simply put, income is defined as money that comes into your personal household, usually generated as compensation in the form of a paycheck for work you and other household members have done.
Net income refers to take home pay or the amount of money earned after payroll withholding such as state and federal income taxes, social security taxes, and pretax benefits like health insurance premiums.
If you are enrolled in a flexible spending account to pay for medical costs, the amount withheld from each check is also on a pre-tax basis.
Always realize that you save on your taxes when you pay for benefits on a pre-tax basis and if used effectively you can build a large nest egg that will allow you to enjoy retirement in a way that it was meant to be enjoyed.
If your employer matches your retirement contributions be sure to contribute at least up to the match and even more if your financial position allows you to do so.
By doing the above you can put yourself in position to live your retirement in a manner that you desire—not in a manner that others desire that you live!
To maximize your retirement returns be sure to start early in your life stage and be sure to put a plan in place that allows you to reach your "retirement number" that you need to reach so that you can enjoy retirement on your terms!
In simple form Net Income is Gross Income less Deductions!
Net Income also includes other sources of income that you may have from rideshare driving. selling goods or services by doing a side job, getting paid for consulting services or selling products you've made or are reselling on eBay/Amazon, your own website, at art and craft shows or other venues.
Another form of income is passive income, which is generated when you rent out rooms, homes or apartments, or you earn capital gains, interest or dividends on investments or interest bearing accounts like savings accounts or some checking accounts.
Other types of income come from royalties, which are gained from agreements made relating to copyrights, patents, or gas, mineral or petroleum properties.
Believe it or not even bartering can be a way of generating income, if you strike a really good deal.
It is not uncommon for consumers to pursue multiple streams of income based on the times that we now live in.
If you are computer savvy you can track your personal finances on software, like Quicken or you can go online to mint.com.
Other helpful links that could help you improve your personal finances and income can be found by going to the credit and personal finance page on this website. It is a page that we feel is the most empowering credit page on the web—visit the page now by clicking here...
Ordinary income is income that is categorized for tax purposes as being taxed in the category that your income level falls based on your filing status.
Ordinary Income will vary from individual to individual and family to family based on the income that you earned during a tax year.
It is important that you contrast ordinary income with long-term capital gains, the rise in the value of investments owned for more than a year, and qualified dividends which are both taxed differently and are therefore not considered to be ordinary income and may receive a more favorable tax treatment depending on your income--so you must be aware of ordinary income and the role that it plays now--or the role that it could play in your future.
Ordinary Income comes in two forms:
1) business income and
2) personal income
In a corporate setting, the term refers to any type of income generated from regular day to day business operations, excluding any income earned from the sale of long-term capital assets, such as land or equipment.
Meanwhile, from a personal perspective, ordinary income can be defined as any sort of cash inflow that is subject to income tax, as outlined by the Internal Revenue Service (IRS).
In a nutshell "ordinary income" is any type of income that is taxable at ordinary rates—according to IRS guidelines.
If you were to collect income from a business venture in which you’re not actively involved, you’re passively earning income. This could include income from rental properties that you may own and investment returns.
There are tax advantages and disadvantages of having passive income and each taxpayer's situation will differ.
Personal income is also known as your "before-tax income" and is used in calculating your adjusted gross income for income-tax purposes.
Personal Income is basically your “Gross Income” that was discussed earlier. It is your total income before taxes or any deductions and can include various sources.
Taxable Income is a tax that governments impose on financial income generated by all entities or individuals within their jurisdiction.
By law, businesses and individuals generally must file an income tax return every year to determine whether they owe any taxes or are eligible for a tax refund.
Personal Taxable Income is derived by including all taxable income sources and subtracting out adjustments, exemptions, deductions and credits to determine your taxable income.
You Must Be Able To Distinguish Between a Tax Credit & a Tax Deduction
It is important that you realize that a tax "credit" reduces your tax dollar for dollar!
For example, if you owed $3,000 on your taxes and you were in the 25% tax bracket and you had a tax credit of $1,000—your taxes would then be reduced to $2,000!
A tax "deduction would also reduce your taxes, however it would not be dollar for dollar—but would depend on your tax bracket!
For example, if you owed taxes of $3,000 and you were in the 25% tax bracket and you had a tax deduction of $1,000—your taxes would then be reduced to $2,750!
The point is that a credit is more valuable to
you than a tax deduction—so always keep that in mind!
You Must Properly Purchase Your Home & You Must Properly Understand Housing Ratios!
Keeping your housing ratio under 30% and your housing and debt ratio under 40% of your monthly income are a wise use of benchmarks.
If your take home pay (or gross income) is $10,000 per month—your maximum mortgage payment should be $3,000.
$3,000/$10,000 = .30
or 30% on the front-end housing ratio (monthly housing payment only versus your monthly income)
If you have monthly recurring debt of 1 year or more such as monthly credit card debt of $500, monthly car payment of $500 and student loan debt of $1,000—your housing and debt ratio would be at 50% which in many cases would signify you had to much debt.
$5,000/$10,000 = .50
or 50% on the back-end housing ratio (monthly housing payment plus your monthly debt payments of 1 year or more versus your monthly income)
Keep in mind that compensating factors—and extinuating circumstances (expected financial windfall, better school district for your kids—etcetera) could make it possible for you to have a need to exceed the above benchmarks—however use caution!
In addition, you must ensure that your discretionary income (mentioned above) is at an acceptable level so that you can live the lifestyle that you desire for yourself and your family.
If you were to eliminate your student loan debt of $1,000 per month prior to purchasing your home—using the above scenario your housing and debt ratio drops down to the more acceptable benchmark area of 40%—now you get the picture?
$4,000/$10,000 = .40 or
40% on the back-end housing ratio (monthly housing payment plus your monthly debt payments of 1 year or more versus your monthly income)
Income tax is a key source of funds that the government (local, state, federal) use to fund its activities and serve the public.
Most countries employ a progressive income tax system in which higher income earners pay a higher tax rate compared to their lower earning counterparts.
That is the case in the United States as well!
The first income tax imposed in America was during the War of 1812 and its original purpose was to fund the repayment of a $100 million debt that was incurred through war-related expenses.
After the war, the tax was repealed, but income tax in the United States became permanent during the early 1900’s.
What it all Means in a Practical Sense
Understanding the various types of income that you may hear or read about from various sources on a daily basis can be difficult if you do not have a mental system to distinguish effectively among the various types.
Below we will review what you have just learned to further increase your understanding.
• You now know that your Adjusted Gross Income represents the total gross income that you earn for the year minus certain deductions.
• You now know that your After-Tax Income represents the amount of money that you have left over after all federal, state and withholding taxes have been deducted from your taxable income.
After-Tax Income is the same as "disposable income"—so be aware of the interchanging use of the terms.
• You now know that your Discretionary Income represents the money that you would have remaining after all of your bills are paid off.
Discretionary Income is income after subtracting taxes and your normal expenses such as rent or mortgage, utilities, insurance, medical, transportation, property maintenance, child support, inflation, food and other miscellaneous monthly expenses that you pay to maintain a certain standard of living that you desire.
• You now know that Disposable Income differs from Discretionary Income.
It is important that you distinguish in your mind that Disposable income is money that you have left after paying your taxes—while discretionary income is money you have left over after paying your taxes “and” mortgage/rent, food, utilities, and life's other necessities.
Disposable Income is income that you have at your disposal "after" the payment of taxes!
Discretionary Income is money that you can spend or save at your discretion after the payment of your taxes "and" monthly expenses!
You now know that disposable income and after-tax income are basically the same thing—just expressed differently.
• You now know that your Gross Income is your total personal income before taking taxes or deductions into account.
• You now know that your gross income is how much you make before taxes. Gross Income is the figure people are looking for when they ask you how much you gross a month.
• You now know that your Modified-Adjusted Gross Income varies according to purpose and who is requesting that you modify.
All modified versions may add certain items to AGI that were excluded in computing gross income.
Common additions include tax exempt interest and the excluded portion of Social Security benefits. Modified-Adjusted Gross Income (MAGI) is often used when calculating the alternative minimum tax (AMT).
• You now know that your Net Income refers to take home pay or the amount of money earned after payroll withholding such as state and federal income taxes, social security taxes, and pretax benefits like health insurance premiums.
In short, gross income less certain deductions equal Net Income.
• You now know that your Personal Income is basically your “Gross Income” that was discussed earlier. It is your total income before taxes or any deductions and can include various sources.
• You now know that your Personal Taxable Income is derived by including all taxable income sources and subtracting out adjustments, exemptions, deductions and credits—to determine your taxable income.
Make it a point to increase your income and reduce your expenses so that you can enhance the future for yourself and your family!
Did you know that you can increase your income by making compound interest work for you and not against you?
By understanding and being able to distinguish among the various types of income and understanding how compounding works you put yourself in position to understand your personal finances in a more intelligent (meaningful and effective way that works to your benefit) manner!
You also put yourself and your mind in a more favorable position where you can control your future in a more "financially alert manner" and in a manner that will lead to true success for you and your family!