Types of Taxable Income: Dividends, Salary, etc.

It’s obvious that (in addition to your filing status) the size of your taxable income is the most important factor in how much tax you’ll be responsible for paying every year. What’s not so obvious is that the calculation of your tax is also affected by the type(s) of income that you earn.

There are four primary categories of income:

1. Salaries and Wages
2. Earnings from Self-Employment
3. Interest Income
4. Dividend Income

Salaries and Wages

Of course, for most people, the majority of income comes in the form of salaries and wages. Salaries and wages are straightforward in terms of taxes because they are taxable at the normal tax rates, and they are subject to normal social security and Medicare taxes.

If you work as an employee, your salary or wages for each year will be reported to you on a Form W-2 at the beginning of the following year. The amount withheld for Federal income tax, state income taxes, and social security and Medicare taxes is also reported on your W-2.

Earnings from Self-Employment

Earnings from self-employment are subject to the same income tax rates as wages or salaries. However, instead of being subject to social security and Medicare taxes, self-employment earnings are subject to the Self-Employment Tax.

For employees of a company, a social security tax of 6.2% and Medicare tax of 1.45% are withheld from each paycheck. The person’s employer is required to pay a matching amount. So the employee is paying 7.65%, and the employer is paying 7.65% for a grand total of 15.3%. When you’re self-employed, you are, in essence, both the employee and the employer, so you get stuck with both halves of the bill (15.3%).

In contrast to people who work as employees (who get their income reported to them on a W-2), business owners are responsible for keeping records of how much their businesses make over the course of the year. If, however, you work as an independent contractor, your income—as long as it’s over $600—will be reported to you on a Form 1099. (If it’s under $600, it won’t be reported to you on any form at all, though you’re still responsible for reporting it on your tax return.)

Interest Income

Most interest income—such as that from a savings account—is subject to normal income tax rates (like salaries, wages, and self-employment income). However, one advantage of interest income is that it is not subject to social security and Medicare taxes. Taxable interest income that you earn will be reported to you on a Form 1099-INT.

Some types of interest income are unique in that they are not subject to Federal taxation at all. This category of income is, understandably, referred to as nontaxable interest income. The two most common sources of nontaxable interest income are bonds issued by state governments and bonds issued by municipalities. One important thing to know is that, while it’s not subject to Federal taxation, nontaxable interest income will often be subject to state or local income taxes.

Dividend Income

Dividends—distributions of a corporation’s profits to the shareholders—are also taxable. Like interest income, dividend income is not subject to social security or Medicare taxes.

Also, dividend income may be subject to lower income tax rates than other types of income. If a dividend meets a list of requirements, it will be referred to as a “qualified dividend.” Qualified dividends are subject to a maximum tax rate of 15%. Generally, dividends that you receive for shares of stock that you’ve held for at least the last 60 days will be qualified dividends.

Because it will be indicated on your Form 1099-DIV (received from your brokerage firm) what portion of your dividends were qualified dividends, it generally isn’t necessary to concern yourself with memorizing all the specific requirements for a dividend to be a qualified dividend.