What Is Income?

Income is money that a person or a business receives in return for working, providing a product or service, or investing capital. A person's income may also derive from a pension, a government benefit, or a gift.

To a government tax agency, income may be taxable, tax-exempt, or tax-reduced.

To an economist, income may be disposable or discretionary.

Key Takeaways

  • Income is the money that people and businesses receive in exchange for working, producing a product or service, or investing capital. Some derive income from pensions and government programs.
  • Businesses earn income from selling their goods or services for a price that exceeds their cost of production.
  • Tax authorities treat income earned through various means differently.


Understanding Income

For most of us, income is the money we use to fund our day-to-day expenditures. The income may be received in the form of wages, salary, freelance payments, or the receipts of a small business.

Investments, pensions, Social Security, and other government benefits programs may also be sources of income. Some receive income through trust funds or cash gifts from family.

Business income can refer to a company's remaining revenues after paying all expenses and taxes. In this case, income is referred to as earnings. Most forms of income are subject to taxation by local, state, and federal governments.

Individuals receive income through earning wages by working and making investments in financial assets such as stocks, bonds, and real estate. For instance, an investor’s stock holdings may pay income in the form of annual dividends.

An individual may also inherit income.

Taxable Income

Most of the above types of income are taxable income, although the tax rates vary, some portions of the income may be tax-exempt, and the rules can be mind-numbingly complex.

In the U.S. as in most countries, earned income is taxed by the government before it is received by the employee. The revenue generated by income taxes finances government activities and programs as dictated by federal and state budgets.

The Internal Revenue Service (IRS) calls income from sources other than a job, such as investment income, unearned income.

Income from wages, salaries, interest, dividends, business income, capital gains, and pensions received during a given tax year are considered taxable income in the United States.

Other taxable income includes annuity payments, rental income, farming, and fishing income, unemployment compensation, retirement plan distributions, and stock options.

Lesser-known types of taxable income include gambling income, bartering income, and jury duty pay.

The types of income listed above would be classified as ordinary income, which is composed mainly of wages, salaries, commissions, and interest income from bonds.

Ordinary income is taxable using so-called ordinary income rates. This type of income differs from capital gains or dividend income in that it can only be offset with standard tax deductions, while capital gains can only be offset with capital losses.

Tax-Exempt and Tax-Reduced Income

Types of income that may be tax-exempt include interest income from U.S. Treasury securities (which is exempt at the state and local levels), interest from municipal bonds (which are not always exempt at all three of those levels), and capital gains that are offset by capital losses.

Types of income taxed at lower rates include qualified dividends and long-term capital gains.

Social Security income is taxable if the recipient has other income above certain levels.

Disposable and Discretionary Income

Disposable income is generally defined as the cash that remains after taxes are paid. Individuals spend their disposable income on necessities such as housing, food, and transportation.

Discretionary income is the money that remains after paying both taxes and all of those necessary expenses. Discretionary income is spent on nonessentials like vacations, restaurant meals, cable television, and movies.

In a recession, individuals tend to be more prudent with their discretionary income. A family may use its discretionary income to make extra payments on a mortgage or save it for an unexpected expense.

Disposable income is higher than discretionary income within the same household because the expenses of necessary items are not removed from disposable income.

Calculated at a national level, both disposable and discretionary income estimates are used by government economists to project the expected amount of consumer spending in the near future.

However, either measure must also take into account the willingness of people to make purchases at any given time, and that varies with the state of the economy in general and the situation of the individual or family in particular.

Examples of Taxable Income

For individuals, ordinary income is made up mostly of the pretax wages they earn from their employers. If, for example, a person works a customer service job at Target and earns $3,000 per month, his annual ordinary income would be $36,000, or $3,000 x 12. If that person has no other income sources, this is the amount that would be taxable as gross income.

If the same person owns a rental property and earns $1,000 a month in rental income, that taxable ordinary income would increase to $48,000 per year.

If the person earned $1,500 in qualified municipal bond interest payments, that portion of income would be tax-exempt.

Taxable Income for Businesses

For a business, ordinary income is the taxable profit earned from selling its products or services, minus its expenses of doing business.

For example, the retailer Target Corp. had about $93.6 million worth of total sales and other revenue in the year that ended in January 2021. The company had about $83 million in costs of goods sold (COGS) and other operating expenses. Target’s ordinary income of $10 million is derived as follows:

  • $93,600,000 - $83,000,000 = $10,000,00

That is roughly the amount of income that Target would be taxed on for the full year. However, businesses are required to pay taxes quarterly.

What Counts as Taxable Income?

Income from wages, salaries, interest, dividends, business income, capital gains, and pensions all are considered taxable income in the U.S. All of these sources of money are classified as ordinary income and are taxable using ordinary income tax rates.

Ordinary income can only be offset with tax deductions.

Capital gains such as income from the sale of stocks that have increased in value can be offset by capital losses like the sale of stocks that have decreased in price.

What Types of Income Are Tax-Exempt?

Tax-exempt include interest income from U.S. Treasury securities (exempt at the state and local levels), interest from municipal bonds (exempt at one or all levels of government), and capital gains that are offset by capital losses.

Types of income taxed at lower rates include qualified dividends and long-term capital gains.

Social Security income may be taxable, depending on how much other income the taxpayer receives during the year.

Inherited money is taxable by the federal government only above very large amounts. Many states have inheritance taxes.

What Differentiates Disposable from Discretionary Income?

This is a difference appreciated mostly by economists.

Disposable income is the amount of money left over after people pay their taxes. Disposable income is all of the money that is available to a person or family after their taxes are paid.

Discretionary income is the money that remains after all necessary living expenses are paid.

Economists are interested in both types of income as they analyze the health of the economy or project the economy's direction in the near future.