An extraordinary lesson on ordinary income.
- Person A makes $100,000.
- Person B makes $50,000.
Who is going to pay more tax?
Well, obviously the guy making $100,000 is going to pay a lot more tax than the guy making $50,000, right? Guess again!
Here’s what’s going on. Not all money is created equal. Not all money is treated the same in the eyes of the IRS. And this is a very BIG idea with ginormous repercussions. Think about it. If you can make $100,000 and pay less tax than your neighbor who makes $50,000, don’t you want to know how you can do that?
So, let’s get a feel for how the IRS looks at different sources of making money and how they tax each.
The good news is that there are really only three types of income to worry about. But honestly, I don’t even like using the word “income” here, because when most people think of income, they think of working at a job and getting a paycheck. And yes, that is income, but some of these others don’t require you working a job, so when I say “income,” keep an open mind as to what this income is.
The first type of income the IRS cares about is called ordinary income.
This is not to be confused with extraordinary income, which is reserved exclusively to describe Adam Sandler’s salary for pretty much any movie he’s ever been in. Okay, no. Not really. There is just ordinary income. What is this ordinary income of which I speak? It’s almost any kind of income you can think of. Yes, it’s the income you get from your job, but it’s so much more. If you rent a room out in your house and get paid, this is rental income and is considered ordinary income. If you own a bond and receive interest, this money is considered ordinary income. If you babysit, that’s ordinary income. If you have a company that makes paper mâché hats, this is ordinary income. If you write a book and I buy a copy from you, that’s ordinary income. If your cat video goes viral on YouTube and you get money from ads, that money is ordinary income. Almost any income you can imagine is considered ordinary income.
So what’s the significance of this?
You may like to earn ordinary income, but the IRS really likes it when you earn ordinary income. Why? They tax it! They get a piece of it! The more you make, the more they get. And it gets worse.
“Ordinary income is delicious cheesy pizza. The IRS knows you have it and will do whatever it takes to get some of it from you. And not just a little, but a lot.”
My daughter loves thick, cheesy pizza. If I only had one slice of delicious pizza, I may try to hide it from my daughter (don’t judge me; it’s pizza!). But sooner or later, she’d see me eating that delicious slice of pizza. She would ask, then beg, then cry, then sulk, then demand some of my pizza. How do I know her precise emotional response from pizza shunning? Yeah, don’t ask.
Ordinary income is delicious cheesy pizza. The IRS knows you have it and will do whatever it takes to get some of it from you. And not just a little, but a lot. They love it and they want a good part of your slice. If you don’t give it to them, they won’t beg, cry, or sulk. They go straight to demanding it and then to locking you up in prison.
That’s ordinary income.
Oh, and I lied. This isn’t the least you need to know about taxes and investing. There’s just one more lesson, I promise. Okay, fine. There are two more. That’s it. No, really. You can trust me!
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.