The Tax Implications of Different Types of Income in the US

How you make an income significantly impacts your tax bill, especially in the United States.

Business Profits and Self-Employment Taxes

When you own a business or are a 1099 contractor, the tax implications are quite different from employment income. If you earned $100,000 in profit and you are single with no dependents, and you claim the standard deduction, your federal tax bill would be around $30,000. More than half of this amount would be the FICA tax on your income. FICA, or Federal Insurance Contributions Act, is a tax that funds Social Security and Medicare. For self-employed individuals, you are responsible for paying both the employer and employee portions of FICA, typically totaling 15.3% of your income.

Employment Income

If, instead of having your own business, you work for someone else and your tax status remains the same, your tax bill drops to around $22,000. This is because your employer pays half of your FICA, reducing your tax liability. This shared financial burden between employer and employee significantly impacts the total tax bill.

Investment Income

When you earn income from investments such as interest, dividends, and capital gains, the tax implications are even more favorable. Assuming the same income and tax status, your tax bill could drop to just $6,000. Most of this income is not taxed at all, and the portion that is taxed is subject to a lower rate than regular income. For long-term capital gains (profits from selling investments that you have held for more than a year), the rate is generally a flat 20% for high-income individuals, whereas for regular income, the rates can be as high as 37%.

Inheritance

When you receive a significant sum through inheritance, the tax implications are minimal if not non-existent. Even if the inheritance is structured as a family trust, the income is typically not taxed. Your tax bill remains zero. This unique benefit of inheritance highlights the significant differences in tax treatment for different types of income.

Income Tax Basics

It is essential to understand that income tax is levied on all income from all sources. You must add up all sources of income and pay income tax on the total. Different types of income are subject to different tax rates. For example, long-term capital gains, as mentioned, are taxed at a flat rate of 20% for high-income individuals. Short-term capital gains, on the other hand, might be taxed at the higher of your ordinary income tax rate.

Additionally, understanding the complexities of tax codes, deductions, credits, and exemptions can further minimize your tax liability. Employing a professional tax advisor or utilizing tax software can provide valuable insights and ensure you maximize the benefits of these systems.