Ordinary income is income from most sources, like your job. It’s taxed the most.
Capital gains are what happens when you sell an investment for more than you bought it for. These are also taxed, but not as much as ordinary income.
And then there is this.
It’s a highly secretive investment. Some of the wealthiest families in the country know about this, but it requires opening an offshore bank account and funneling money through the Caymans into a wholly owned subsidiary that . . . just kidding!
Although some of the wealthiest families do invest in what I’m about to share with you, it is not really a secret and it doesn’t require an offshore account or funneling of money anywhere. It’s pretty straightforward and easy for anyone to do.
It’s called municipal bond income!
Let’s break it down. Municipal. What does that mean? It means a city or state. What’s a bond? An investment where you lend money.
So city/state + bond.
You lend money to a city or state and all that wonderful interest income they pay you? That’s pure lentils! The IRS plugs their collective noses and goes on a strollin’ past you. They don’t want any part of this income. It’s all yours.
How much tax will you pay if you make $100 in municipal bond income?
Now rank these from who pays the most to who pays the least:
1) Capital gain from selling a mutual fund
2) Income you get from working a job
3) Municipal bond interest
The correct order is 2, 1, and 3.
Okay, the takeaways…
My daughter likes pizza, and the IRS is not really fair or consistent in how they view income or how they tax it. Ordinary income is income from work, business, selling products, and interest you earn on your investments. Ordinary income is taxed the highest. Next are capital gains. These are gains from selling an investment for more than you bought it for. These are taxed, but not as much as ordinary income. Finally, we’ll save the best for last. Bonds from cities or states are called municipal bonds. What makes these unique is that any interest you get from these are tax-free! These are the lentils of the income world. The IRS doesn’t want any part of this income.
Maybe we had it all wrong about the IRS. Maybe they are good guys after all. Could it be? We shall see in the next lesson . . .
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.