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Thursday, January 12, 2012

Income taxes 101

Income is categorized into approximately 24 types according to the Internal Revenue Service (IRS). Although there are several different types of income, they all can be labeled as taxable income. However, not all kinds of income are taxable at the same rate.

Tax rates can also change between tax years due to changes in tax law that can affect how tax is calculated, when tax is calculated and what is or isn’t tax protected. Before going to detail about the kinds of income individuals and households are subject to, the video below explains how tax calculators determine income tax.


Wages and salaries


A common type of taxable income described by the IRS is wages and salaries. This income is reported on the Form W2 that is sent to income recipients near the beginning of tax filing season. Even though this is one type of income, it is taxed at differing rates determined by total taxable income; for the 2010 tax year, these tax rates can range from around 10 percent to 39 percent. Total wages and salaries is not usually the final amount of income that is considered taxable because it doesn’t take into account exemptions, deductions and credits.

Capital gains


Tax on capital gains varies on whether those capital gains are offset by capital losses and if the capital gains are acquired through a tax protected financial vehicle such as  a Roth IRA. According to the Tax Foundation, the maximum capital gains tax for the 2010 tax year is 35 percent. This amount applies only to short-term capital gains and not long-term capital gains which have a 15 percent maximum rate for the same year.

Interest and dividends


Personal income tax
Income tax is different from payroll tax
People also often receive Form 1099s that provide a record of other income such as income from interest and dividends. Tax on dividends can vary and may not be taxable at the same rate as normal income. These types of dividends are called qualified dividends and must meet certain requirements to qualify for the lower tax rate. These qualifications can be reviewed at the University of Connecticut Business School. Interest on financial securities is often taxable unless those financial instruments are non-taxable as is the case with some types of municipal bonds.

Social Security


Income from social security entitlements may or may not be taxable depending on the individual circumstances. The IRS states persons whose only income for a given tax year is social security may not even need to file a tax return. Income from social security is recorded on Form SSA-1099 and is reported on Form 1040. If social security is taxable, it is usually taxed at the same rate as income from wages and salaries or the standard tax rate that applies to the given taxable income amount.

Retirement income


If income is received from retirement accounts such as Individual Retirement Accounts (IRAs),and 401(k)s, whether or not that income is taxable can also depend on the individual situation. For example, if the income is directly transferred to another retirement plan, i.e. not received but redirected there’s a good chance it may not be taxable. However, if the income is paid to the retiree, and is from a tax deferred retirement account such as a traditional IRA, then the income is more likely to be taxable.

Several additional types of income tax exist and it is always a good idea to verify tax questions and information with the IRS at 1-800-829-1040, or a qualified tax professional before sending a completed tax forms to the IRS for processing. This is because there may be overlooked tax rules, better ways to reduce tax and possible errors in the tax documents to be sent to the IRS.

Image license: Chris Potter, CC BY 2.0