Income: What It Means and How It's Taxed With Examples

What Is Income?

The term income refers to any type of compensation or benefit received in exchange for work performed or for capital invested. Income can come in the form of the money you receive from your employer or the payments you receive on your investments. Income can be divided into several categories, including gross versus net income and earned versus unearned income.

How Income Works

Income is any compensation you receive in exchange for performing services, selling goods, or investing your money. Compensation is usually in the form of money, but it can also come in other forms. The paycheck you receive from your employer is considered income. Dividends and interest from your investments are also considered a form of income.

Federal and most state governments want to collect a percentage of these transactions and they do so in the form of taxation. According to the Internal Revenue Service (IRS), income is "money, property, goods or services." It indicates that most income is taxable even if you don't use it right away or if it's paid to someone else on your behalf.

Most people think of their weekly, biweekly, or monthly paychecks when they hear the word income but it can go beyond that. Income includes distributions from investments and retirement plans, and even that bottle of wine you might have accepted for walking your neighbor's dog for them. In most cases, you must report it to the IRS and pay taxes on it.

Types of Income

Gross Income vs. Net Income

Your employer may pay you a salary of $2,000 weekly but it's highly unlikely that they'll hand you a paycheck in that amount. They'll make several deductions from this amount for taxes and other obligations such as contributions you might make to a retirement plan or insurance premiums.

The initial amount before deductions is your gross income. What remains after deductions are made is referred to as your net income.

Unearned Income vs. Earned Income

Unearned income is typically derived from investments. As the name implies, it is money you didn't work for, although you may have worked for the dollars you invested. This includes dividends, taxable interest, capital gains, and retirement plan distributions. It also includes benefits such as the taxable portion of any Social Security you might collect or unemployment compensation.

Earned income is paid to you in exchange for working or performing a service. You're required to complete and submit a Form W-4 when you begin a new job, detailing personal factors like your marital status and how many dependents you have. This information affects how much your employer will withhold in the way of income taxes and send to the government on your behalf.

Ordinary Income vs. Capital Gains

Earned and unearned income fall into the category of ordinary income. Capital gains are income received from the sale of capital assets such as real estate or stocks.

Assume you purchased a parcel of land years ago for $100,000. It's since appreciated in value and you sell it for $200,000. You've realized a $100,000 capital gain and you must pay tax on that gain but not at the same rate that applies to your ordinary income. Some capital gains have their own tax rates and they can be much kinder than ordinary income tax rates depending on your overall income. The rates increase as your income increases.

Most capital gains are taxed at 0%, 15%, or 20% but some exceptions exist for items like collectibles and qualified small business stock. These are taxed at a rate of 28% as of 2025. You can subtract capital losses from this type of income as well if you lose money on an investment subject to more rules. Compare this to ordinary income tax rates ranging from 10% to 37% as of 2025.

Capital gains tax rates apply only if you own the asset in question for more than one year before you sell it. You must pay tax at your ordinary income tax rate if you own the asset for one year or less. The difference can be that one single day that exceeds a year.

How Income Is Taxed

Several types of income are categorized in the Internal Revenue Code (IRC) and each can be subject to its own tax terms, obligations, and rules. In the United States, the payor and the recipient must report their income by filing W-2 forms and various 1099 forms with the IRS as well as to the recipient's state government if applicable.

Working outside the U.S. won't spare you even if you also live outside the U.S. but you're an American citizen. You must file a tax return and pay taxes on the income you receive. The IRC allows you to exclude some foreign income—up to $130,000 as of 2025. You can exclude $126,500 for tax year 2024.

FICA

Social Security tax is withheld from your gross income at the rate of 6.2% of earnings up to $176,100 a year as of 2025. Your employer must match that by contributing an additional 6.2%. The same arrangement works with Medicare but the rate is 1.45% each for you and your employer.

Self-employed individuals must pay both halves because the government takes the position that they're both employee and employee. They're obligated to make payments voluntarily every quarter.

Some taxpayers whose modified adjusted gross incomes (MAGIs) after claiming tax deductions and credits exceed certain thresholds must also pay a net investment income tax at a rate of 3.8%. The MAGI thresholds range from $125,000 to $250,000 depending on your filing status. You can pay the percentage on your net investment income if it's less, however.

Gift and Estate Taxes

The monetary value of gifts is typically taxable but the federal gift tax is paid by the donor—not the recipient. Connecticut is the only state that imposes this type of tax at the state level.

An estate tax is imposed when property or money owned by an individual is transferred to living beneficiaries after the individual's death. The federal government allows estates to transfer up to $13.99 million in money and property to beneficiaries without taxation as of 2025, however. Only 12 states and the District of Columbia impose an estate tax at the state level.

Tax Breaks on Ordinary Income

The IRS isn't as heartless as most people believe. The IRC is laden with tax deductions and tax credits you can claim to reduce either your taxable income or the amount of tax you owe.

Tax credits subtract directly from the tax you owe and some are even refundable. The IRS will send you the money if any is left over after erasing your tax obligation. Tax deductions are amounts you can subtract from your income. You're obligated to pay tax on only the balance that remains. The standard deduction is an example. It's based on your filing status and ranges from $15,000 to $30,000 in tax year 2025.

Your other option is to itemize your deductions, subtracting expenses you've paid all year, such as mortgage interest, state and local income taxes, property taxes, or donations to qualifying charities. You can't do both, however. Itemizing or claiming the standard deduction is an either/or decision.

The Bottom Line

Income is virtually anything you receive from working, investing, or selling property. The more income you have, the more you'll pay in taxes, at least in the United States. And it's not just about taxes. Your income determines your standard of living and quality of life.