All income is NOT created equal. This is a great summary about how taxes affect how much you really get to keep from your income depending on the income type. Moral of the story: INVEST!

All Income Is Not Created Equal

This post was originally published in 2017 and updated on 6/19/2024.

One of the most impactful first lessons in personal finances involves illustrating how compound interest works. Investing your money results in exponential rather than linear growth due to earning income on your investment earnings, not just your contributions. There’s another very important lesson as well, though, that is often overlooked. This lesson centers on the varying potential for different types of income to grow your wealth.

It’s true. A dollar isn’t simply just a dollar, and all income isn’t the same. Why? Because of a complex tax code.

With a federal income rate as high as 37%, some state rates at nearly 15%, and FICA taxes at 7.65%, a significant portion of your hard-earned money may be going straight to the government. Just how much taxes you are subject to depends on the specific type of income that you are earning.

So What Are These Taxes Exactly?

Federal Income Taxes

Of course, federal income taxes are much more complicated than simply taking your income and multiplying it by the published tax rates. Deductions and exemptions also reduce your income, and the tax system is progressive, meaning that your income is taxed incrementally, starting at lower rates.

The 2024 federal income tax brackets for married and single filers are shown in the chart below. These tax rates are referred to as “regular” or “ordinary” rates. As you might expect, this applies to essentially all types of income that the IRS doesn’t explicitly specify as qualifying for “preferential” tax rates, which generally include qualified dividends and long-term capital gains.

Investment income is also subject to a net investment income tax of 3.8% for high-income individuals ($200,000 for single filers and $250,000 for those married filing jointly).

State & Local Income Taxes

Of the 41 states with an income tax, most start with the adjusted gross income number from the federal income tax return. Certain additions and subtractions are then made to arrive at a state-taxable income number, upon which state income tax is calculated.

Nearly all states tax wage and salary income, although there are a select few that only tax dividends and interest. In addition, there are other states that don’t tax retirement and pension income (at least to some extent). There are varying rules for each state, but it is worthwhile to do the research to find out how your income is being taxed in your particular state.

In addition to state taxes, many U.S. cities also impose an income tax. At the point that you’re paying federal, state, and local income taxes, you’re certainly ready to implement some tax planning strategies!

FICA Taxes

To fund the Social Security and Medicare programs, employees must pay 7.65% of wages, adjusted for a few pre-tax items such as medical premiums. Employers are also required to pay an additional 7.65% on the employee’s behalf, and self-employed individuals pay both the employee and employer portions for a total rate of 15.3%.

The 7.65% FICA tax has two parts: Medicare and Social Security. The Medicare tax portion (1.45%) has no wage limit, but the Social Security portion (6.2%) is capped at $168,600 in wages for 2024. In addition, those with high incomes (over $200,000 depending on filing status) currently pay an additional Medicare tax of .9%.

And How Exactly Do Taxes Affect Income?

Employee Salary & Wage Income

The majority of Americans are employed by someone else. As an employee, your salary and wage income are taxed at “ordinary” federal tax rates, which are as high as 37%. That same income is generally taxed at a state and local tax level as well, depending on where you live.

On top of all of that, you’ll also pay FICA taxes on your wages. It’s as if going to work every day isn’t taxing enough already (get it?!).

Fortunately, it is possible to exclude a portion of your wage income from tax. This includes any amounts you contribute directly to pre-tax retirement and health savings accounts, deductions for medical insurance, and a few other items. Moral of the story: take advantage of as many pre-tax savings opportunities as you can, especially if you have a high income.

Self-Employment Income

Now, if you want to pay a lot in taxes, you should definitely start your own business and report it as either Schedule C income or as an LLC, where the income flows to your personal income tax return. The income potential is unlimited, but the government is going to want its share, too, of course.

This income is subject to ordinary tax rates and the employer and employee portions of FICA taxes. This is definitely something to consider if you’re considering replacing your current job with a freelancing or consulting job or adding an additional side hustle. You need to know what your real takeaway income will be after additional taxes are considered to see if it’s really worth it (and it very well may be!).

As a self-employed person, you are responsible for calculating and remitting your income tax estimates and payroll taxes to the government, so you probably “feel” it more than if you were an employee.

Business Income

Owning a business gives you more opportunities to manage your taxes, including FICA taxes. There are legal structures, such as setting up a corporation or S-corporation, that can allow you to reinvest the properties without paying a significant amount in taxes

There are legal structures, such as setting up a corporation or S-corporation, that can help reduce your tax burden immensely. This area of the law can be very complicated, so it’s essential that you either have the knowledge regarding the legal and tax implications of different business structures or hire someone who does.

For example, the wage income that you earn from an S corporation is subject to ordinary tax rates as well as FICA taxes. However, the remaining income that “flows” through from the S-corporation to you personally is not subject to FICA taxes. This can result in sizable tax savings.

As another example, a corporation may be used if the income earned is taxable at a lower income rate than you’d pay on your personal tax return, although you’ll ultimately be taxed when you take money out of the company in the form of a dividend or capital gain (however, these are taxed at lower rates).

Rental Real Estate Income

A rental property offers the opportunity for additional tax deductions, such as depreciation. A leveraged property can provide some significant tax benefits. However, ultimately, the net income (income less applicable rental expenses) is taxed at ordinary tax rates. Rental income is not considered self-employment income, though, so only income tax rates apply, not FICA taxes.

Rental properties are generally taxed in the state where they are physically located, so that is an important consideration as well. It may be more advantageous to invest in rental real estate in states with low or no income tax.

If you’re a real estate professional, some different rules apply, which we won’t discuss here.

Retirement  & Pension Income

Distributions from traditional retirement and pension accounts are taxed at ordinary income rates. Because the government allows you to deduct the amount you contribute to retirement accounts from your gross income before calculating income subject to tax (either through 401k contributions or other pre-tax IRA contributions), you haven’t previously been taxed on this money or the income generated over the years. When the money is withdrawn from the account, it’s all subject to tax.

Roth retirement accounts are treated completely differently. With Roth retirement accounts, you have already paid tax on the money you contribute to the account. If the requirements are met, including not withdrawing the earnings before age 59 1/2, you won’t pay tax on the earnings or your contributions in the account.

There is a penalty of 10% for withdrawing retirement funds early, so if you decide that you want to take all of your money out and do something else with it, your income will be reduced not only by federal income taxes but by an extra 10% as well.

There are quite a few states that don’t tax at least a portion of retirement and pension income, even though they have an income tax.

Investment Income

Investment income includes interest, dividends, and capital gains from the sale of investments. If you don’t have enough other reasons to get started investing, tax minimization is a great one!

All investment income is not treated equally, though. Interest from bank accounts and bonds and short-term capital gains (for assets held less than a year) are taxed at ordinary income tax rates. Dividends from assets not held for a certain holding period are also taxed at regular rates.

Qualified dividends, those held from stocks that have met the holding period requirement, are taxed at much lower rates. Long-term capital gains from assets that are held for at least a year are also taxed at these lower rates. The preferential tax rates are:

  • 0% if in the 10% or 12% tax brackets
  • 15% if in the 22%, 24% or 32% tax brackets
  • 15% or 20% if in the 35% tax bracket (the limit is in the middle of this bracket)
  • 20% if in the 37% tax bracket

Offsetting these low tax rates is the 3.8% net investment income tax that applies to high-income individuals, which does minimize the impact of the lower rates, but to a minimal extent.

So What Do I Do To Keep More of My Income?

The investors win here by a landslide, while those who live paycheck to paycheck are the biggest losers in terms of tax impact. High spenders often rely heavily on highly taxed wage and salary income for an extended period of time without shifting any of this income to investment income, which greatly reduces the tax burden.

Owning your own business can be another great way to shield some of your income from taxes if it is structured in certain ways that allow for reinvestment or reduced amounts of salaries and wages. Often, the cost of professional advice to implement a sound plan is considerably less than the benefits received.

Let’s consider a single person living in Michigan with $100,000 taxable income (the remaining income after deductions and exemptions). The table summarized below shows this person’s total tax burden.

To summarize:

  • As an employee, this person would be paying over $30,908 in taxes.
  • If this person earned the same amount as an independent contractor, they would pay an additional $8,446 in taxes because they also owe the employer portion of FICA taxes.
  • If they set up an S-corporation and took half the profit as wages and half as flow-through business income, they would be in the same overall tax position as if they were an employee.
  • If this income were all from rental real estate, they would be $8,446 richer due to not having to pay FICA taxes.
  • Instead, if this person were older and retired, they may be able to exclude a portion of their retirement income from state taxes (in Michigan) altogether and pay only $22,463 in taxes.
  • And, if they were really smart, they would pay the least taxes of all if they were able to derive all of their income from investments. At a 50/50 income mix of bond interest and qualified dividends/capital gain income, they would only pay $18,963 and if absolutely all of their income was from qualified dividends and capital gains, they’d only pay $12,196. That’s well less than half the taxes on wage & salary income!

By considering the impact of taxes on income, you can take action to ensure that you keep more of your own money in your pocket rather than paying the lion’s share to the government.

What do you do to minimize income taxes on your income?

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9 Responses

  1. We plan to have a zero tax liability for this year. We d not have any employment income, so everything is from investments. The minimal self-employment income is offset by deductions.

    I, curious why your last two examples would owe any taxes at all. With no earned income, their cap gains and qualified dividend rate would be zero. Right?

    1. Zero tax liability would be amazing! You’re clearly doing some good tax planning.

      The last two examples still owe taxes because even investment income fills the tax brackets (looking at the chart at the beginning of the post). So, to show this with the last example which includes only preferentially taxed capital gains and qualified dividends, $37,950 of the total $100,000 taxable income is taxed at 0%, filling up those first two brackets. Then the remaining portion is taxed at 15%. If there was a mix of earned income and investment income, the earned income would fill the brackets first, then the investment income.

      1. Ah, yes, thanks. I glazed over the drawdown being 100% gains. In my case some of the money is basis and some gains. So, for example, I might draw $75k but half or less is gains, leaving me in the zero bracket. Plus deducting our tithe buys us some additional buffer.

  2. Both of my 401K and rollover IRA contributions are my ways to minimize income taxes. I just started contributing to my IRA last year by contributing $4K. Now this year I’m maxing out my contributions to my IRA and will continue to do that.

    1. We have the option to either contribute to a traditional or roth 401k with my husband’s employer and the Roth 401k doesn’t impose the same limit that the Roth IRA does. However, we’re currently sticking with the pre-tax contributions to the 401k for tax reasons. We’ve contributed to a Roth as well, mainly to diversify our income sources in retirement so that we can stay in a low tax bracket. It’s hard to balance this!

  3. Yes, as self employed you have to pay the additional 7.65% FICA tax. But you can contribute up to $69,000 in your 401k as opposed to the $23,000 cap as a W2 employee, which will reduce your tax burden. You also have a myriad of tax deductions you can take that are not available as a W2 employee (e.g. phone, internet, home office, mileage, some meals, office supplies, etc., etc.). Educate yourself so you don’t pay a penny more than you absolutely have to. Thank you Kathryn, for sharing your knowledge.

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welcome!

I’m Kathryn Hanna-wife, mother of 3 and a Certified Public Accountant. I love to budget (really, I do!) , build spreadsheets and spend money on travel, sewing supplies and good chocolate.

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