How to Think About Income – The Types, Sources, and Tax Implications of Each | AWM Insights #166
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Episode Summary
We continue our series on the Multi-generational Wealth Formula. This week, we focus on income - the most common types and sources, active versus passive income, and how they are treated differently for tax purposes.
The most common source is typically called Employment Income or W2 Wages. This income comes from work you do as a formal employee of a company. Athletes are paid Employment Income from the team they play for. On the non-athlete side, founders, senior executives, and employees are typically paid their salaries this way. This income can be subject to the highest tax rates.
Any off-the-field income (endorsement income, etc.) is considered self-employment income, independent contractor income, or 1099 Income. Non-athletes can earn this through consulting work or other types of independent work. It is paid as though you are your own business, which has its benefits and drawbacks. There is certainly more flexibility for tax planning but more responsibility to make sure taxes due are paid on time.
The last category we discuss can be broadly thought of as investment, or passive income, and there are a few different sources – interest income, dividends, and capital gains. Rental income would also fall into this category. These income types are typically generated from an investment portfolio and the tax treatment varies widely.
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Episode Highlights:
0:00 Intro
0:24 A quick review of what we’ve covered in the series so far
0:44 What are the different types of income & how are they taxed?
1:11 Employment income or W2 Wages
2:02 Self-employment income
3:02 Investment, or passive, income
5:47 What's the tax treatment of these sources?
7:04 Benefits of capital gains and the compounding effect
7:34 Text us!
+ Read the Transcript
Brandon Averill (00:03): All right, everyone. Welcome back to another episode of AWM Insights. We're continuing down the path of really digesting and pulling apart our multi-generational wealth formula. For clients listening, you've undoubtedly heard us talk about this in the past, but we thought it would be great to break down little pieces into segments here.
(00:24): And so far, we've hit on human capital, how important that is, and the different types of human capital that exist; and those were physical, intellectual, and social. And ultimately, what comes out of that human capital is income and gross income. So before-tax income is what we're talking about when we talk about income.
(00:43): And so today what we're going to dig into a little bit is what are the different types of income that you actually can earn? And then not all of this income is treated exactly the same; so they're taxed differently, some of them take more effort, all those different types of things.
(00:59): We'll dig into this today. And then we're going to talk a little bit about tax, and then we'll end up going into a whole tax planning episode after this to foreshadow a little bit.
(01:11): When we think about income, so often we think about our employment income. So for our athletes listening, this is what the team pays you. Or for our founders listening, this is what the company pays you. And you're an employee of that company, and so you get paid wages for that employment.
(01:31): And most of us know you get W-2 at the end of the year, and that's what the tax filing form is called. This is a good thing, right? The employer has the obligation to withhold taxes out of your paycheck. It's a little bit more consistent. They take some of the planning burden off of you. But with that comes a little bit less flexibility from a tax-planning standpoint. Like I said, we'll get into that in a future episode. But that's the primary way that most of us get our employment income.
(02:02): There's another way, which is more of a self-employment type income, and you'll often hear this referred to as independent contractor or referred to as the tax form you actually get, which is a 1099. For athletes listening, this is how you're getting income from your endorsement deals, for instance, or other sponsorship-type deals that you've done. Or if you start a sole proprietorship and you're doing some sort of business activity, you're going to get a 1099. With this, taxes aren't withheld. So this is a surprise to some of you guys.
Justin Dyer (02:41): You don't get to keep it all, right?
Brandon Averill (02:42): Yeah. You get your first Tops check or your first Nike check, and everything seems great, and then all of a sudden, you find out that you got to pay taxes on it. Hopefully, you haven't spent it all at that point. But the onus is on you to do some planning around that. But it also provides you a lot more flexibility.
Justin Dyer (02:58): That's right.
Brandon Averill (02:59): So we'll get into that. But definitely... Then there's the investment side, right?
Justin Dyer (03:03): Yep. So your investments kick off income. We're not just talking about income that is earned directly, let's call it from your efforts, your human capital; physical, intellectual, social. This is where we're starting to get a little bit into the nuances, into the weeds if you will, of this virtuous cycle we've hit on with respect to this multi-generational wealth formula.
(03:26): But after you've built up a little bit of a nest egg and investment portfolio, that portfolio kicks off interest, dividends, and capital gains. Hopefully, you're doing some smart tax planning, and we're going to get into that, as you alluded to, to really minimize the tax burden there.
(03:44): Hopefully, you're maximizing the income that your portfolio is kicking off in the most efficient way. Again, we're really going to get in the weeds there. There's a lot of nuance and moving parts to that.
(03:55): But this is also getting into the topic of passive income, so put a placeholder in that. We'll jump into that when we talk a lot about the very end of this formula, which is the resulting investment portfolio. Again, we're starting to get to a point where the cycle is repeating on itself.
(04:12): But suffice it to stay, you're using your human capital, you're driving gross income. You have to pay taxes on it, right? We all know that. And then your investments are starting to really feed on themselves. That's part of this power of compound interest that investing provides, and it really produces that long-term growth of wealth that we all know at least has existed in the past.
(04:37): Income or interest dividends and capital gains are all part of that. So interest is typically kicked off from fixed-income or bond-type investments. Dividends, that comes from stocks. Not all of them, but stocks, in general, will pay a dividend. When they release their earnings, you get a small piece of the profits essentially distributed to you as an equity shareholder. That happens whether you're holding the stock directly or through a mutual fund or ETF, a pooled vehicle.
(05:06): And then capital gains, the last piece of it, is when you go to sell an asset, whether it be a stock in the stock market, a bond in the market, or a real estate property, if there is an asset and it has appreciated in price, you're going to pay... or you're going to earn a gain on that. There's a tax that results as well. Whether it's a short-term gain or a long-term gain, again, something we'll jump into depends on how much tax burden you get from that.
(05:33): But these are other sources of income, especially once the portfolio has been built, these are aspects that really drive continued success and allowing you to reach your priorities.
Brandon Averill (05:45): And I think a good place to maybe tie this out is, with that income, they're not all treated equally from a tax perspective. So you hit on capital gains, but those are taxed favorably in most cases, versus other income that we're generally receiving that are going to be taxed at our ordinary income tax rates.
(06:04): And so clients that are listening, we harp on this quite a bit, is that income for you guys and gals that are in the highest tax bracket is something that we would... Unless you need it, but if you don't need it, we would prefer to prioritize things that are going to have a capital-gains treatment longer term. And so that's going to help us to decide which investments potentially to make and which ones not to make.
(06:28): And everybody isn't created equal. So your buddy down the street that's in a low tax bracket, he's got a couple of rental properties, no big deal. That income is adding to his ordinary tax bracket. Not a big deal.
Justin Dyer (06:39): That's right.
Brandon Averill (06:40): You're making millions of dollars a year, you're in the highest tax bracket, income from rental properties; not that it's bad, but you just got to look at it from a different lens.
(06:49): And so all these different incomes are great. You want aspects of all of them as part of your income portfolio if you want to call it that. But we do need to be really thoughtful about what the taxes are, what that net impact is to us at the end of the day.
Justin Dyer (07:05): The one thing I'd just add from the different tax treatment on all these things, one beautiful thing about gains, and we'll probably jump into this next week, so teaser for next week, is capital gains can typically be deferred for really, really long periods of time.
(07:20): And if you just understand the general math around compounding, that's a great thing, as opposed to income. Hey, you get it this year. Guess what? You likely have to pay tax on it when that money hits your account. And so that's the beautiful thing about capital gains.
Brandon Averill (07:34): Absolutely. Well, hopefully, this is helpful, just talking about the different types of income that could be coming to you, like we have talked about throughout the episode.
(07:42): Next week we'll talk about the tax planning to get around as much of the tax as possible from each of these different segments of income, and ultimately help to build that multi-generational wealth for you. But until next time, own your wealth, make an impact, and always be a pro.