The Two Types of Income

These days, people get money in all kinds of ways. However, one of the most common ways is via earned income. And, while you might think that all income is earned income, that’s not actually the case. There’s also such a thing as unearned income, and it’s important to differentiate between the two, especially if you have both, in order to handle your taxes correctly.  

What is Earned Income?

As the name implies, earned income is money that comes from working. Or, if you’re disabled, your disability payments also count as earned income. When you have earned income, you’re eligible to contribute to an IRA or a Roth IRA, and you may be eligible for certain other benefits as well. And, of course, earned income is taxed. It is subject to Medicare and Social Security taxes, as well as to income taxes.  

What is Unearned Income?  

You may never have heard of unearned income, but it’s actually quite common. Any time you have money coming in from something other than working or disability payments, you have unearned income. This money might be alimony payments from a former spouse, annuity payments you receive, or various types of interest income.  

It’s important that you are aware of any and all unearned income you receive so that you can report it properly come tax time. That’s right—unearned income has to be reported to the IRS as well. It’s not subject to payroll taxes, which is a relief to many people, but it is taxed as income. However, taxation rates may vary depending on the type of unearned income you have, so it’s wise to work with a tax professional to make sure you don’t accidentally overpay or underpay on any of your earned income.  

As you can see, there are two very different types of income, and the IRS wants to know about both of them. Whether you have only one type of income or both, make sure you keep careful records, know and follow the tax rules related to your earnings, and pay the IRS what it’s owed each tax period. Otherwise, you could find yourself facing penalties and interest, which can cut into either type of income significantly

Estimated Taxes

The federal income tax is a pay-as-you-go tax. You must pay the tax as you earn or receive income during the year. There are two ways to pay as you go, either by employer withholding or estimated tax payments.    

Employer withholding. If you are an employee, your employer generally withholds income tax from your pay. In addition, tax may be withheld from certain other income such as pensions, bonuses, commissions, and gambling winnings. If all of your income will be subject to income tax withholding, you probably do not need to pay estimated tax. Events during the year may change your marital status or exemptions, adjustments, deductions, or credits you expect to claim on your tax return. When this happens, you should complete a new Form W-4, Employee’s Withholding Allowance Certificate, so that the appropriate amount of tax is withheld.

Estimated tax. Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes income from self-employment, interest, dividends, alimony, rents, gains from the sale of assets, prizes and awards. You also may have to pay estimated tax if the amount of income tax being withheld from your salary, pension, or other income is not enough.

Estimated tax is used to pay not only income tax, but selfemployment tax and alternative minimum tax as well. If you do not pay enough by the due date of each quarterly payment period you may be charged a penalty even if you are due a refund when you file your tax return.

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Six Ideas to Cut your 2014 taxes.

Proper planning now could reduce your 2014 income taxes. Here are six ideas to get your planning started.

1 Limit wage and investment income. As many high-income taxpayers found out in 2013, there are new Medicare surtaxes on wage and investment income. Try to reduce your wage/investment income for 2014 below the thresholds in order to avoid the increased Medicare taxes.  

2 Defer your income.  When possible, make maximum contributions to your deferred compensation account, such as a 401(k), 403(b), etc. This will not only reduce your wage income subject to the new Medicare taxes, but will also reduce your current taxes overall. If your employer doesn’t offer this type of savings account, consider a traditional, deductible IRA.

3 Make an installment sale. If you are selling investment or rental property, consider an installment sale to spread the gain on the sale over a number of years.

4 Consider municipal bonds. Review your portfolio to see if municipal bonds are a good fit for you. Muni yields of 3.6% equate to a taxable yield of 6% at the highest bracket. Municipals issued by your own state are free from both federal and state taxes. And municipal bond interest does not trigger the new Medicare taxes on investment income.

5 Use a health savings account (HSA). Consider tax-deductible contributions to an HSA if you have a high-deductible medical plan. The contributions not used for current medical expenses can be left in the account to grow tax-free until needed.

6 The best way to reduce your taxes is to know how the tax code applies to you specifically. There is a right and wrong way to do things from a tax standpoint. The tax savings in selecting the right way will reduce your taxes not only for 2014 but also for years to come. 

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Same Sex Couples and Taxation

Recent changes in tax law are affecting all kinds of people from all walks of life. Surprisingly, one group of people that they are affecting is same-sex couples. While same-sex couples may not be able to get married in every state in the United States just yet, married same-sex couples are now allowed to file their income taxes jointly or as “married filing separately,” even if they live somewhere where the marriage is not recognized by the state. 

While many people regard this recent change as a step in the right direction for homosexual couples, the new law could potentially result in increased taxes for same-sex couples. Couples who will likely face the highest increase in taxes are couples in which both spouses are employed.

Whether you are affected by this new tax law or any other, you should know that there is available tax help in Naperville. You can get the tax help you need, regardless of your situation, by contacting Susan S. Lewis, Ltd. of Naperville.

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