Question

Explain how different types of income received will make a difference in the amount of tax you pay.

Answer 1

Taxation laws in most of the countries, including the U.S., treat income from different types of sources differently for the purpose of income tax calculation that a person needs to pay. Certain types of income are exempt from income tax. For example, the interest on municipal bonds, life insurance proceeds, a portion of Social Security benefits, gifts, and the value of some employee benefits are not included in taxable income. So if there are two persons both earning $20,000 per month but one of them has most of this attributable to his normal taxable salary whereas the other has half of his income coming from one of the above mentioned tax-exempt sources, the tax liabilities of the second person will be lesser than that of the first person.

Another consideration is that income from some other sources, though not completely exempt from income tax, is taxed at lower rates. For example, long term capital gains (gains arising from sales of assets) are taxed at lower rates than ordinary income. People having an ordinary tax rate of up to 15% do not have to pay any tax on long term capital gains whereas those having ordinary income tax rates between 15% and 33% only need to pay 15% of tax on income from long term capital gains. (These rates keep changing as per revisions in tax rules that we can refer to, on the IRS website & other official sources for detailed tables of applicable rates.)

So we see that, in addition to the amount of income, the source of that income also has a great bearing on the income tax that we need to pay.