The Guide to Understanding Income

If you’re reading this, you’ve likely encountered some sort of economic disaster (recession, COVID-19, natural disasters, war, etc). We want to help you feel better prepared (financially) if any of these events were to happen again. The first step of taking control of your financial future is to understand income.

What Is Gross Income?

Gross income is the total amount of money received by a person or business before they pay income taxes. Gross income can consist of wages, dividends, capital gains, business income, retirement money you’ve withdrawn and other income.

What Is Net Income?

Net income is the total gross income minus the taxes that are to be paid to the government agencies and other deductions. For businesses, net income is the total revenue minus all expenses, taxes and costs.

What Is Adjusted Gross Income (AGI)?

Adjusted gross income (AGI) is gross income minus any necessary adjustments to that income.These adjustments can include student loan interest, alimony payments, contributions to retirement, education expenses, etc. Adjusted gross income (AGI) can not be higher than gross income (for obvious reasons).

Income Types

Types of Income Income can be categorized into two main categories – Passive Income and Active Income. Passive income refers to the money earned on an investment or previously completed work. Active income is money that is earned in exchange for goods or services.

What Is Passive Income?

Passive income is income from a rental property, business, or partnership that generates income, but the person is not actively involved. Passive income is typically taxable, but it may be handled differently by the IRS. The IRS defines passive income as “net rental income or income from a business in which the taxpayer does not materially participate.” The IRS does not always consider portfolio income to be passive – so be sure to check with a tax professional.

Types of Passive Income

Rental Properties

Ghost Investments

Self-Charged Interest

What Is Active Income?

Wages

Wages refers to income that is earned through your job on an hourly basis. The more hours that you work, the more hours that you are paid for, meaning the more income you earn.

Salaries

Salary is similar to wages. Salary is the annual income paid to you by your company, typically paid out weekly, bi-weekly, or monthly. Your salary amount is typically agreed upon during your hiring process and is spelled out in an agreement that you sign with your company stating that you both agree to the exchange.

Commission

Commission is income earned through completing a task. Commission is most common in sales positions. Commission is most commonly a specific percentage of a sale paid to you (the seller) or a flat rate for each unit sold.

Interest

Interest is a tough concept to grasp. Simply put, interest is income that your money generates for you. Interest is typically paid on money that you have deposited. Interest rates will vary bank-by-bank, state-by-state, etc.

Gifts

Gifts, yes – birthday presents, graduations, etc., are a nice unexpected source of income. You don’t typically need to claim any gifts on your taxes, but again – check with a tax professional before you make any decisions.

What Is An Income Stream?

An income stream is exactly what it sounds like – a steady stream of income. To be more clear, an income stream is a series of payments made on a regular cadence. H1: Credit and General Tax Questions

What Is A Good Debt to Income Ratio?

While “good” is subjective, lenders prefer that your debt-to-income ratio be between 36% – 38%. Ideally, your rent/mortgage should be less than 25% – 28% of your gross income. If your monthly gross income is $4,000, then your total monthly debt (mortgage/rent, car, student loans, credit cards, etc.) should be close to $1,520 ($4,000 x .38 = $1,520). If that’s not attainable for you right now,or if you need help understanding your income, we recommend checking out our personal finance software with the best budgeting features.

What Is Income Tax?

Income tax is a tax imposed by governments on income generated by individuals and by businesses within their governing jurisdiction. There are also laws associated with income taxes. By law, individuals and businesses must file an income tax return annually to determine how much of their gross income was taxable. Those income taxes are used to fund public services and service as income to the government. The amount of money that one owes in income taxes varies. In the United States, our income tax structure is tiered. So everyone’s income is taxed at the same rate for every dollar within a specific bracket. Below is an example of how much money someone who makes $60,000 (gross annual income) is taxed (with fake tax brackets and tax rates – made up for demonstration only): Income: $60,000 Income Bracket Income Tax Rate Income Tax Due $0 – $10,000 5% $500 ($10,000 x 0.05 = $500) $10,001 – $20,000 7% $700 ($9,999 x 0.07 = $700) $20,001 – $40,000 10% $2,000 ($19,999 x 0.10 = $1,000) $40,001- $70,000 12 % $3,600 ($29,999 x 0.12 = $3,600) $71,000 – $110,000 14% $0 ($0 x 0.14 = $0) Totals 11.3% $6,800 In this 100% made up example, someone making a salary of $60,000/year would pay 11.3% of their total income ($6,800) in income taxes annually.

What Is Taxable Income?

Taxable income is defined as the portion of income that is subject to income taxes. Taxable income is typically Adjusted Gross Income minus allowable deductions. Be sure to speak with an accountant if you need tax advice – it’s not something you should take lightly.

Understanding Income

It’s obvious that income is not a quick and simple topic to cover. It can be overwhelming to try to understand, especially when taxes are involved. Luckily for you, Financial Hope offers a great personal finance tool for you, and you can try it for free today.