Taxpayers frequently receive income from several different sources. Not all types of income are taxed at the same rate or according to the same rules. So knowing what gets taxed — and how — is important as you fill out your return each year. Here’s a look at the rules for each category of taxable income.
Wages and Salaries
This is income you earn from your job, along with certain fringe benefits, like company-paid gym memberships, company vehicles, and holiday cash gifts. Employers are required by law to report what they pay you on a W-2 form, which they typically send to you at the end of the year. Most employees choose to have their employers automatically withhold taxes from their paychecks, in which case the company does the math. You do have the option of claiming that you are exempt from withholding on your W-4 form. (Just remember that you’ll still have to pay taxes on your income at the end of the year.)
The taxes you pay on your wages and salaries take many different forms, from federal and state income taxes to Social Security and Medicaid taxes. Your employer is required to pay half of your Social Security and Medicaid taxes, so what shows up on your W-2 is only the half you’re required to pay. The rate of your federal income tax depends on which tax bracket you fall into: The higher your tax bracket, the higher your tax bill will be.
If you are self-employed, you will be taxed for the net profits from your business at the same rate as wages and salaries. Independent contractors typically receive Form 1099-S reporting income from their clients — as long as it’s over $600 — but otherwise, you are required to keep track of your income (and expenses) yourself.
One important thing to remember: You are allowed to deduct certain business expenses to offset your gross profits, so your net profits may be considerably less than the gross amount of money you took in. Social Security and Medicare taxes work differently for self-employment income: You have to pay a self-employment tax that covers the full rate for these social services, meaning you’re shouldering the entire bill rather than covering only half.
Interest is taxed at the same rate as salaries, wages, and self-employment, but it’s not subject to Social Security and Medicare taxes. In most cases, taxable interest income will be reported to you on a Form 1099-INT. Some types of interest income are not subject to federal taxes, though. Bonds issued by state governments or municipalities are the most common sources of this type of nontaxable interest, although both may be subject to state and/or local taxes.
Dividends are distributions of a corporation’s profits to part-owners called shareholders. Like interest, dividends aren’t subject to Social Security or Medicare taxes. Some dividends are taxed at the same rate as wages and salaries, but some are eligible to be taxed at lower long-term capital gains rates. These dividends, called “qualified dividends,” are subject to a maximum tax rate of 20 percent, and typically apply to investments held for longer than 60 days.
Capital gains are profits from the sale of capital assets such as stock, a business, or a parcel of land. Short-term capital gains — those held for less than a year — are taxed at the same rate as wages and salaries. Long-term capital gains — those held for more than a year — are taxed at a maximum rate of 20 percent, though the exact rate depends on your tax bracket.
401(k)s and 403(b)s are both popular employer-sponsored retirement plans that automatically divert a portion of your pretax paycheck to the plan. The money that goes into these plans is not subject to federal income tax, though it is subject to Medicare and Social Security taxes. When you are 59½ you are eligible to withdraw from your retirement account, and those withdrawals will be taxed as income. If you take distributions before that age, you’ll face an additional 10 percent tax, unless the distribution qualifies for an exception.
Pension and annuity income is fully taxable as long as you didn’t contribute anything to the accounts from your salary. As with 401(k)s and 403(b)s, you’ll be hit with an extra 10 percent tax if you withdraw from these before age 59½.
Traditional IRA income is likewise fully taxable upon withdrawal, and it faces the same age restrictions as 401(k) plans. As with 401(k)s, the money that goes into these plans is tax-deferred, lowering your income tax burden while you save. Roth IRA and 401(k) income is tax-free. That’s because, in contrast to traditional IRAs and 401(k)s, you pay income taxes on the money you contribute before it goes into your Roth IRA or 401(k).
Money you make from renting out property is subject to the same rate of taxation as wages and salaries, minus any expenses associated with the rental. For this reason, it’s important for owners of rental property to keep detailed accounts of their income and expenses, which can include everything from cleaning costs and garbage collection to transportation to and from the property, and even the cost of advertising for new tenants.
Less-common kinds of income are reported on Form 1040 as “Other Income.” These can include gambling winnings or other prizes, canceled debts, hobby income, jury duty pay, and barter income. They are taxed at the same rate as wages and salaries.
A version of this article appeared in our partner magazine, The Essential Tax Guide: 2023 Edition.