Income: What it Means and How it’s Taxed

Definition

Income is any compensation or benefit received in exchange for work, the sale of goods, or capital investment. It includes wages, salaries, tips, dividends, interest, retirement distributions, and gains from selling assets. Most income is taxable, though specific types and amounts may be excluded or taxed differently.

Key concepts

Gross income: total income before deductions.
Net income: take-home pay after payroll taxes, retirement contributions, and other withholdings.
Earned income: money received for working or providing services (wages, salaries, tips).
Unearned income: passive income from investments (dividends, interest, capital gains, some retirement distributions).
Ordinary income: typical earned and unearned income taxed at regular income-tax rates.
Capital gains: profit from selling capital assets (stocks, real estate). Tax treatment depends on how long you held the asset.

Ordinary income vs. capital gains

Short-term capital gains (asset held ≤ 1 year) are taxed as ordinary income.
Long-term capital gains (asset held > 1 year) generally receive preferential tax rates (commonly 0%, 15%, or 20%), though exceptions exist (e.g., collectibles, certain small-business stock).
Example: Buying land for $100,000 and selling it later for $200,000 creates a $100,000 capital gain. If held more than one year, long-term rates apply; if not, it’s taxed as ordinary income.

How income is reported and taxed

Employers and payors report wages and payments using forms such as W-2 and various 1099s. Recipients must report income on their tax returns.
U.S. citizens and residents generally must file U.S. tax returns and report worldwide income, though some foreign-earned income exclusions or credits may apply.
State income tax varies: several states do not impose a broad personal income tax (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Wyoming). New Hampshire taxes only dividends and interest; Washington taxes only capital gains (rules and lists may change over time).

Payroll taxes and self-employment

Social Security and Medicare (FICA) are withheld from employee pay:
Social Security: 6.2% withheld from wages; employer matches 6.2%.
Medicare: 1.45% withheld; employer matches 1.45%.
Self-employed individuals pay both the employee and employer portions (self-employment tax) and typically make quarterly estimated payments.

Other taxes related to transfers and investments

Net Investment Income Tax: may apply to certain high-income taxpayers on investment income.
Gift tax: generally paid by the donor for large gifts (federal rules apply; some states may have additional rules).
Estate tax: may apply to transfers of an estate at death if the estate exceeds federal or state exemptions.

Tax breaks and ways to reduce taxable income

Tax deductions reduce taxable income (standard deduction or itemized deductions such as mortgage interest, state/local taxes, property taxes, charitable contributions — you choose one approach).
Tax credits reduce tax liability directly; some credits are refundable, meaning they can generate a refund beyond your tax owed.
Deductions and credits have eligibility rules and limits; choose the option that best lowers your tax bill.

Bottom line

Income encompasses nearly everything you receive from working, investing, or selling property. Its type and timing determine how it’s taxed. Understanding distinctions—gross vs. net, earned vs. unearned, ordinary income vs. capital gains—and available deductions or credits helps you manage tax liability and plan for your financial well‑being.

Sources

Internal Revenue Service (IRS) — guidance on taxable income, capital gains, withholding, and credits/deductions
Tax Foundation — state income tax overviews