Not All Income Is Equal Because of Taxes: 3 Types of Income

The Declaration of Independence declares that all people are created equal.

That is not true about income coming from investments. Many of your neighbors forget this fact to their detriment.

One of the major problems people often do not understand is taxes. You can reduce different types of income with different levels of taxation.

Be informed.

What are the issues?

Income comes in many forms. Wages and bonuses you earn, sales or income from hard assets, Social Security, and sudden wealth are examples.

For many people, especially those in or approaching retirement, income from their investments is a major way to fund their lifestyles.

Some people lump income into one big category. For those of us who pay taxes (hint: most people pay taxes!), this would be a mistake. The IRS and state tax authorities view income under several categories.

The table below illustrates the different categories of income from a tax perspective and typical sources of such income:


Introducing Different Tax Categories of Income

Income Type Examples of Investment Sources
Ordinary Income
  • REIT’s
  • BDC’s
  • Immediate Annuities
  • Fixed Income
Qualified Dividends
  • US Stocks
  • Foreign Stocks (sometimes with additional foreign withholding tax)
K-1 Pass-through Income
  • MLP’s (public and private)
  • Hedge Funds (LP’s)
  • Business Interests (LP’s)
  • Private Equity (LP’s)

The table below sheds light on how tax laws might apply for each category of income. This includes both taxable and qualified accounts (typically IRA’s or other retirement accounts).


Different Tax Treatment for Sources of Income in Taxable and Qualified Accounts

Income Type Tax Treatment for Taxable Accounts Tax Treatment for Qualified Accounts
Ordinary Income
  • Not taxed specifically in current year
Qualified Dividends
  • Not taxed specifically in current year
K-1 Pass-through Income
  • Return of Capital – taxed at long-term capital gains only when partnership unit is sold
  • UBTI – potential taxes owed to IRS
  • Possible additional state tax filings and payments needed
  • Certain deductions might offset
  • If UBTI exceed $1,000 for an IRA, federal tax is due (special filing Form 990-T)



Here is some additional color on the specific tax treatment of each of these categories:

  1. Ordinary income

    1. Taxable accounts
      1. Income other than long-term capital gains. Wages, salaries, and dividends are examples.
      2. Ordinary income is taxed under the marginal tax bracket as defined by the IRS.
      3. A range of itemized deductions might be able to offset a portion of ordinary income.
    2. Taxes on ordinary income are not relevant when held in retirement accounts.
  2. Qualified Dividends

      1. Taxable accounts
        1. Taxed at the long-term capital gains tax rate (used for gains on the sale of investments held for greater than 1 year).
        2. No cost basis, but also favorable tax treatment due to (typically) lower long-term capital gains tax rate.
      2. Only offset on income tax returns is capital losses (selling assets below purchase price and writing off all or a portion of the difference).
      3. Taxes on qualified dividends are not relevant when held in retirement accounts.
  3. K-1 Income Pass-through Income

    1. Tax considerations for taxable accounts
      1. Partnerships like LP’s and Master Limited Partnerships (MLP’s), both public and private, pay income that the IRS treats differently from ordinary income.

      2. Investors at the end of each year receive a form K-1. A good portion of your income should be tax-deferred. However, there are complexities:

        • Most income qualifies as “return of capital”, which is recorded for tax purposes not as income, but rather as a reduction of the cost basis of the shares the investor purchased.
        • If and when the investor sells the shares of the partnership, the investor will pay capital gains tax on the difference between the share price and the cost basis. Hence, the return of capital is considered “tax-deferred” into the future, not “tax-free”.
        • Unrelated business taxable income (UBTI) is “income regularly generated by a tax-exempt entity by means of taxable activities.” Not only is this income taxed, but it has the potential to bump up the investor’s marginal tax bracket if it causes the investor’s total income to exceed certain thresholds.
        • Taxable income from MLP’s might offer potential offset in the form of depreciation and other deductions. List these items on your K-1.
      3. You might have to file income tax forms in states where you do not live but where the MLP might do business.

    2. Taxes could still be quite relevant even if held in retirement accounts (such as IRA’s).
      1. Retirement accounts (IRA’s) – if total UBTI on all your investments in an IRA exceeds $1,000 in a year, you must file a special form and pay tax on it.
      2. In addition, you will need to file a special form with your 1040 (Form 990-T).


One additional consideration specific to income generated from investments with a foreign domicile is withholding tax.

Some countries have tax treaties with the US and do not withhold additional tax from dividends. However, others do not. The situation varies by country.

The UK poses an interesting example for foreign investors. Sometimes, certain structures (such as UK corporations) are exempt from dividend withholding tax. Yet, other structures in the same country (such as UK REITs) are subject to dividend withholding tax.


How we can help you deal with the issues

We would be happy to schedule a free consultation so we can help you figure out the best ways to generate income after taxes.

Do not go broke by stretching for income! Read our white paper to learn the 3 common potholes you need to steer clear of.


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