What is Income?
Income is an actual or recorded inflow of cash or other assets. The term is used in many different contexts.
How Does Income Work?
Let's say John Doe works for Company XYZ. His salary is $100,000 per year. This is his income.
If the inflation rate is 3% per year, then the value of that $100,000 falls by 3% a year as goods and services get more expensive. As a result, after the first year on the job, John's salary is really only able to buy $100,000 – (3% * $100,000) = $97,000 of goods and services. In year two, John's salary is then only worth $97,000 – (3% * $97,000) = $94,090. The longer this goes on, the less John's $100,000 salary buys. By the end of five years, John's salary would be 'worth' only $85,873. His 'real income' is $85,873.
Gross income is income before taxes or adjustments. In the accounting world, gross income is usually the same thing as gross profit (that is, revenue minus cost of goods sold). So let's assume restaurant chain XYZ sold $1 million worth of food last year. The cost of that food was $330,000. Thus, the company's gross income was $1,000,000 - $330,000 = $670,000.
For individuals, gross income is not the same as taxable income. For example, if John makes $1,000 a week and uses $250 of that to invest in his 401(k) plan, his gross income would be $1,000 but his taxable income would be $750.
Ordinary income is income that is not a capital gain, dividend or other income subject to special taxation.
In the United States, income is taxed progressively, meaning that there are a series of brackets in which income is taxed. For example, in 2006, the first $7,550 of ordinary income reported by a single person was taxed at 10%; then the income over $7,550 but below $30,650 was taxed at 15%. The income over $30,650 but below $74,200 was taxed at 25%; the income over $74,200 but below $154,800 was taxed at 28%; and the income over $154,800 but below $336,550 was taxed at 33%. Any income over $336,550 was taxed at 35%.
Why Does Income Matter?
Wages are the most common kinds of income. 'Unearned income,' such as capital gains, is taxed at different rates, as are dividends. Interest income is sometimes exempt from ordinary income taxes (as in the case of most municipal bond investments). Dividends paid to the shareholders of a company are another kind of income, and those investors might even rely on those dividend payments for their day-to-day living expenses. Dividends usually come in the form of cash, but they can come in the form of stock, which can also be regarded as income for tax purposes.
Knowing how taxes on income affect one's portfolio can make a big difference in investing decisions. For example, one big advantage to owning dividend stocks is their generally favorable tax treatment. Until 2003, dividends were taxed as ordinary income -- up to 38.6% -- and capital gains were taxed at a much lower 20%. In 2003, the tax on most dividend income and some capital gains fell to 15%. Not only did this encourage companies to increase dividends, it encouraged stock ownership because interest income from Treasuries and money market funds were still taxed as ordinary income.