By Dr. James M. Dahle, WCI Founder
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:
Income Tax Illustration
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 onto Form 1040. Capital gains go onto Schedule D, which flows onto Form 1040. Roth conversions and any IRA distributions if you have non-deductible money in them flows onto Form 8606 and then onto 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!
Really cool way to think about things!
I just did my own taxes for the second time. But this was the first since my income streams have been diversified. You’re absolutely right that you learn so much in general by doing your own taxes but also about where your money is coming from and how tax efficient it is.
My wages from my W2 job still comprise ~90% of my income but rental income and private business income quickly became a solid 10% in just the last few months. Our dividends and distributions are likewise a very low percentage.
What doesn’t show up is the forced appreciation on our rental properties which has resulted in the biggest increase in our net worth! More about that here:
https://prudentplasticsurgeon.com/my-net-worth-biopsy/
Great post!
Yes, a plastic surgeon interested in finance will grow his or her net worth very quickly. Everyone is supportive of net worth posts for a while, but like most bloggers, you’ll find the support drops off rapidly as your net worth hits 7 figures and if you’re like most, you’ll stop publishing it at that point.
Nice summary. But, for many of your readers the term “royalties” can be confusing. For those who are writers, inventors, or artists, royalty income is often reported on Schedule C rather than Schedule E. The IRS publication 525 is itself confusing on this, as it notes royalties for copyright holders should be Schedule E but that:
“if you hold an operating oil, gas, or mineral interest or are in business as a self-employed writer, inventor, artist, etc., report your income and expenses on Schedule C (Form 1040).”
Most authors do not own copyright to their published works, their publishers do. I am not sure if that is the correct distinction.
In any case, as an academic who published books and textbooks (and now retired but still receiving royalties from book sales), I have always reported those on Schedule C. I had a fancy accountant for a couple years (due to some other complexities) and he used Schedule C. Turbotax does so automatically, but that could be because of the occupation category I use.
I don’t think the IRS cares all that much since it is mostly all taxed at the same rate whether it is Schedule C business income or Schedule E royalty income. Frankly, I’d love to see some simplification around Schedule E. It’s a mess.
If you invest via crowdfunding and get a K-1 with depreciation but no income, can you use that depreciation to lower any other of your taxes? and if so which ones can you deduct (to later pay with capital gains recapture) and which ones can you NOT deduct?
thanks!
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I don’t understand the petty mindset of having issues with those who make a lot with hard work and innovation, especially if they don’t become successful on the backs of others and if they contribute via teething to moral causes of their choosing.
It is the same mindset that cheers catching up but frowns upon getting ahead. I wont say if one political persuasion does this more than the other…
You can use depreciation against similar income from another property or carry it forward. But assuming you’re not a real estate professional you can’t use it against your earned income. You can’t use it against your capital gains or dividends either.
thanks! Would income from hard money loans or say income from a site like acretrader count? or does it have to be just from real estate income?
Count for what exactly? Depreciation does not offset debt income, but it does offset rental income. Thus why debt real estate goes in retirement accounts when possible and equity real estate goes in taxable accounts most of the time.
WCI, as someone who invests in private Real Estate funds, I’m interested to see what you do for multi-state filings.
Do you file for every state, every year or do you wait for an asset sale or closing of the fund?
My research on the subject suggests that there is no consensus. There’s advocates for both sides.
Each side has pros and cons. Filing every year lets you carryover the depreciation when the time comes for return of capital; but the cost can be prohibitive.
What do you do?
btw, excellent post. hopefully we’ll get one for deduction in the future.
I file all the state returns that I’m required to file. It varies by the fund and the year quite honestly. I follow the advice of my accountant on which ones to file, but she’s been confused at times too. Between the two of us, we can usually figure it out. The additional tax preparation cost and complexity is definitely a downside of private real estate investments.
But as far as “carrying over the depreciation” my accountant’s opinion was that I did not need to file in every state JUST to do that. That it can be added to the return when I do eventually have to file and I won’t lose that benefit. I’m following her advice on that aspect, so I’m only filing in states where I have income requiring me to file there.
That’s very helpful. Thanks Jim.
Would you please recommend the name of your personal CPA and financial advisors, I am sure they are excellent
Thank you
I am a physician with a net worth of approx., 3 to 5 M, In approx. 5 years I expect to have a net worth of more than 10 M, does it make sense to make a Delaware Dynasty Trust so that I can pass upto 11.6 M of Estate to my only Child and avoid probate taxes? I heard this limit will go down to 5 M soon,
Also does a family foundation make sense over DAF?
Any advise and suggestion will be much appreciated, Thank you.
It depends. Not enough info. If you want to try to pass more to your kids than the estate tax exemption then it may make sense for you.
Yes, the estate tax exemption may go down. It may also go up by the time you die.
A family foundation has some advantages and disadvantages over a DAF. DAF is easier and cheaper, but a foundation is more flexible and can pay its directors a salary.
One aspect of my services is tax preparation. Explaining to individuals how money is taxed is perhaps the most difficult part of my practice. Maybe I’ll just refer them to this site.