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There are lots of different sources of income out there and most of them are taxed on your income tax return. Whether you file your own tax forms or pay someone to do it for you, it is helpful to understand exactly how they work. Understanding can keep you from being ripped off and unnecessarily audited, but most importantly, it can help guide you to live your financial life in such a way that you pay less in tax!
Your income primarily shows up on IRS Form 1040 and its accompanying Schedule 1, but Schedules B, C, D, E, F, and Form 8606 feed into those two forms with more specific information. Schedules E and F are by far the most complicated of these and frequently drive white coat investors to give up on DIY tax preparation. If you have a question about Form 8606, I assure you the answer is on the Backdoor Roth IRA Tutorial page somewhere.
The income section of Form 1040 is pretty straightforward.
The income section of Schedule 1 is also simple:
However, many people aren’t sure exactly how all of these schedules work together and how your income flows between them. So I have put together this handy, dandy chart to demonstrate.
Wow! That looks really complicated. Let’s go over it in depth a bit. Let’s start with the basic stuff.
For most people, most of their income comes in the form of wages, salaries, and tips (not TIPS), so it should be no surprise that that income goes on line 1 of Form 1040. If you’re retired and living on pensions (including 401(k)s), annuities, or Social Security, that goes on lines 5 and 6.
Qualified dividends (generally the ones you get from your stocks and stock mutual funds) and most IRA distributions also go directly on to Form 1040.
All other forms of income flow through another schedule or two. Taxable interest and ordinary income go on to Schedule B, which flows on to Form 1040. Capital gains go on to Schedule D, which flows on to Form 1040. Roth conversions and any IRA distributions if you have non-deductible money in them flows onto Form 8606 and then on to Form 1040.
Everything else goes through Schedule 1, which in turn flows on to Form 1040. Alimony and unemployment go directly on to Schedule 1.
If you own a non-farm business, that goes from Schedule C to Schedule 1 to Form 1040.
Farm income goes from Schedule F to Schedule 1 to Form 1040.
Everything else, partnerships, S Corps, trusts, royalties, and rental income goes on to Schedule E, which, you guessed it, then flows to Schedule 1 and on to Form 1040.
I listed three other sources of “income” that some people have. However, none of these are taxed and so do not actually flow onto your tax return at any point. These include loans (tax-free but not interest-free), appreciation (don’t have to pay until you sell), and Roth IRA withdrawals (tax-free if you follow the rules.) Return of your principal/basis from an annuity, life insurance policy, or investment is also tax-free “income.”
Where Does YOUR Income Come From?
After putting that chart together, I started getting curious to see where our income comes from, especially since we file almost all of those schedules every year. (Still need a farm, I guess.) Thanks to some of our real estate and small business investments, we don’t file our taxes until Fall now, so I’ll pull out our 2019 tax return to use (although I’ll use line numbers from the 2020 forms). Although appreciation is the greatest source of our year-to-year wealth increase, it doesn’t count as income, so I’ll ignore it here. It’s also easy to ignore loans and Roth withdrawals, since we don’t have any.
We have something on lots of lines, but let’s get real, it’s all basically coming from the businesses we own, whether my clinical partnership, The White Coat Investor, or some of our “investment businesses.” Even the “wages” line is really just income from The White Coat Investor. As an S Corp, it pays us wages and distributions, a ratio we manage very carefully to maximize the 199A deduction. Interest and dividends don’t add up to a very high percentage for us and we don’t generate capital gains thanks to tax-efficient investing strategies. In fact, we deduct $3,000 of capital losses against our ordinary income each year. Speaking of investments, we show a zero on the line for rental income, but that’s not because we didn’t have any. It’s because that income was covered by depreciation and so is tax-free, or at least deferred. We paid a few bucks in taxes on some Roth conversions that show up on the IRA and pension lines too.
It’s interesting to step back and look at all that. For someone who approaches financial independence from an income perspective (rather than an asset perspective) it might look like we’ll never reach financial independence. In reality, we already have. Even if you wiped out all of that earned income, there is still a significant amount of income from interest, dividends, real estate, and passive partnerships. In addition, we could pull money from IRAs or 401(k)s, withdraw money from Roth IRAs tax-free, or simply sell some investments (almost all of which would be tax-free thanks to the high basis we have maintained by donating appreciated shares to charity and thanks to large amounts of tax losses picked up during the last bear market.)
The beautiful thing about all of these assets is that we pay no taxes at all on them until such time as we want the money to spend, and even then, a great deal of it is not taxed. It doesn’t show up on our return at all. Nowhere on the return does it ask the value of our businesses, our taxable mutual fund holdings, our real estate, or our retirement accounts. Whether it’s $100,000 or $100 million, it doesn’t affect how much we pay in taxes. At least until we die and pay estate taxes!
It’s important to understand your income and how it flows through your tax return (if at all). Understanding the tax code can pay dividends as large as the ones from your investments.
What do you think? How does your income break down? How many of these schedules do you file each year? Comment below!