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There has been a plethora of back and forth in the HD Forum recently about what constitutes income. I hesitate to wade into these stormy seas. But what the heck. I wrote an article a while ago that discussed the various meanings of income that the tax code uses. Head there if you want a discussion of Gross income, Adjusted Gross Income (AGI), Modified AGI, Taxable income, and Combined income.
Right off the bat I’ll state that this argument will never be won. Because income is inexorably tied to taxes, and taxes are mind-numbingly complicated, our individual views of what constitutes income are a source of confusion. I like to think of these primary categories – the examples are illustrative, not comprehensive.
Earned Income – salaries, tips, bonuses, net self-employment earnings, …
Investment Income – interest, dividends, capital gains, rents, royalties, non-qualified annuities, …
Retirement Income – Social Security Benefits, Pensions, withdrawals from retirement accounts like IRAs, 401ks, qualified annuities …
The tax treatment of items within a category are not necessarily the same – think short-term vs. long-term gains. Pensions are taxable, but Social Security Benefits may be partially taxable. Annuities and retirement account distributions that contain an amount of post-tax contributions are partially taxable.
For retirees who continue to work, any earned income is subject to FICA taxes. Retirement and investment income are not subject to FICA taxes. Further, the Social Security earnings test does not consider retirement or investment income. But the definition of combined income, which is used to determine what amount of your Social Security Benefit is taxable, includes retirement and investment income.
And this is just the Federal tax code. States have a variety of definitions of income for tax and rebate programs. Income, like beauty, is in the eyes of the beholder.
I look at funding our retirement as a multi-variate problem. I’m lucky enough to have a traditional pension, Social Security, and financial resources in pre-tax and post-tax accounts. I also have real estate that provides rental income, and could be converted to liquid assets. And we aren’t close to RMDs yet.
I use these resources to fund our retirement. We have non-discretionary and discretionary expenses. To be honest, our discretionary expenses greatly exceed our non-discretionary expenses. To the extent our total expenses exceed our combined fixed income (Pension & SS) I make decisions on how to use our other resources to fill the gap. I make choices considering tax implications, portfolio makeup, and other considerations.
I fully recognize that many retirees don’t have the resources, and choices that I, and many in the HD community, have. I see them every year at tax time. But even people of modest means have some choices, and are required to make some choices. The more they understand, the better their choices, and the higher their standard of living.
Thanks for wading in and pointing out the numerous ways in which income is defined. I couldn’t help but think of a situation in which someone recives their final paycheck on their last day of work and spends it on the first day of their retirement. In the course of one day, earned income becomes retirement income. Or is it simply spending short-term savings?
Thanks. I was thinking about how we characterize savings in this discussion. The Life-cycle hypothesis talks about consumption smoothing, and dis-saving in retirement, basically spending down our savings. I remember several older relatives who kept fairly large sums of cash in a shoebox, or old metal box. They accumulated this over time and used it when needed. It performed the role of smoothing out their consumption.
Great Job!
English is such a great language. Definitions are allowed, even encouraged, to be flexible in everyday use to help people communicate. Unlike my mother who would correct which words I should use to express myself, there is no one who polices how adults communicate in a Humble Dollar type of environment. And, if someone is successful in their own financial affairs they are entitled to use words any way they want to.
However, there are environments which require more precision. When you read a contract, there is always a section that defines what the terms used in the agreement mean. And, when you deal with the IRS, you must understand how they define the language which expresses their rules.
So, even in the Humble Dollar environment, when you refer to topics in the Tax Code, you should follow/communicate your ideas using the IRS definitions.
There is no blended environment. You cannot use the word income without a definition if you also refer to income taxes in the discussion. To do so creates confusion as those who do understand and follow how the IRS speaks will immediately feel a discordant note and write comments.
It is the writer of words who is responsible to be sure that what they write is understood by their readers. When terminology such as the word income is used it is the writer’s job to understand that the word has many meanings and to be sure which meaning of the word they intend that the reader should have in mind.