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What exactly is “realized income”?
What are the essential elements you should know!
In this article, I will break down the notion of Realized Income so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
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What Is Realized Income
Realized income is an income concept referring to how much income you actually earned or received.
Realized income is also known as taxable income.
For example, if you work on a job and receive a salary or wages, you have “earned” and “received” your income.
The same thing could be said with other types of income like money you earn on your investments.
If you receive interest income or dividend income, you have earned the money that you received.
The notion of “realized” income is important and must be nuanced with “economic” income.
When you refer to economic income or economic gain, you are referring to the appreciation of the value of your asset “on paper”.
If you buy shares of stock or a real estate property that appreciates in value, your economic gain is unrealized or only on paper until you sell the asset.
Once you sell the stock or property to realize your gains that must be reported on your income and on which you will eventually need to pay taxes.
The reason why the notion of “realized income” is important is to determine how much taxes you will eventually need to pay on your income.
When you are able to identify how much realized income you have, you can then determine how much taxes you may have to pay.
Let’s take an example.
If you are working on a job and have a realized income of $20,000, you may be taxed on that amount.
However, if you still have not realized the income, from a tax perspective, you may still not have any tax liability or exposure.
Investors looking to make the best investment decision must consider the notion of realized income to assess how much taxes they may have to pay on their investments.
As part of a sound tax planning strategy, they’ll calculate their annual realized income or other to ensure they understand their tax liability on the different types of realized income they generate.
Realized Income Definition
According to Investopedia, a realized income is defined as follows:
Realized income refers to income that you have earned and received, such as income from wages or a salary as well as income from interest or dividend payments.
In essence, when you earn an income by working on a job or from your investments, you have a “realized” income.
Why Is Realized Income Is Important
It’s important to know how much money you are earning and on which you will be expected to pay taxes.
In fact, there appears to be a correlation between wealth and realized income.
It appears that the wealthiest individuals in the world have a lot of assets but have little realized income.
What this means is that wealthy individuals are able to take advantage of the tax laws and tax strategies allowing them to keep most of their income in their pockets and minimize their tax liability.
The more you can cut down on the taxes that you have to pay, the more you can increase your returns and wealth over time.
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Another important factor to consider in building wealth by understanding what income is taxed in what way is to dedicate your time and focus on ways you can make money without having to pay much taxes.
For example, an employee earning a salary or wages will have a high tax exposure as salaries and wages are heavily taxed.
If you are a self-employed person, you can benefit from certain tax deductions allowing you to reduce to a certain extent your taxes payable.
If you earn money through capital gains and through your investments (when your money is making you money), you may have a better tax position.
If you make the right financial decisions and earn your income in a strategic way, you too can develop wealth without having to work that much harder.
How To Calculate Realized Income
Calculating realized income is quite simple.
By adding the income that you effectively received from all sources, you are essentially calculating your total realized income.
If you are an employee, you calculate your realized income by adding your wages, salary, bonuses, commissions, tips, or any other type of compensation that you may have received from your employer.
Imagine that you also had some investments on which you earned both dividend and interest income.
In that case, you will add all the dividends and interest income you received on top of your total employment income.
Once you calculate the total of what your employer has paid you during the year along with the money you earned from your investments, you will get to your total realized income.
The reason why it’s important to calculate your total realized income is that you will eventually have to pay taxes on this amount.
As a result, you want to make sure that you are properly accounting for the income you realized to ensure that you are paying the right amount of taxes.
If you want to use a realized income calculator, you can find any software solution that allows you to tabulate all your income (from all sources) and give you a total.
For most people calculating realized income is easy as there may be one or a few sources of income.
However, active investors and traders may need to get a software toot allowing them to keep track of all their trades and income they earn and realize in various ways.
Reducing Realized Income
Are there any benefits in reducing your realized income?
It’s certainly beneficial to have a strategy or plan to minimize taxes on the income that you earn (in legal ways of course).
By reducing your tax liability, you will be able to keep more of the money that you effectively earned.
If you are an employee earning a salary or wages, you may be able to reduce your realized income by considering 401K contributions or something similar.
If you have investments, you may be able to consider strategies where you withdraw poorly performing investments to realize a loss to potentially offset another type of income that exposes you to tax liability.
Anyone, with a little effort or some tax planning, may potentially be able to save some taxes here and there.
The more you are able to minimize your tax bill, the more money you can keep.
The wealthy Americans understand this game very well.
They spend a lot of money on their financial advisors, tax experts, accountants, and other professionals so they can put together complicated schemes allowing them to legally avoid paying taxes.
The net result is that they keep most of the money they earn!
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Realized Income vs Recognized Income
What is the difference between realized income and recognized income?
When we talk about realized income, we are referring to different types of income that you have earned and on which you will be required to pay taxes.
On the other hand, recognized income is a type of income that you may have to “recognize” as income (or not) and ultimately pay taxes or not.
For example, if you sell your main residence, you may benefit from certain income tax exemptions and may not be required to pay taxes on your capital gains.
As a result, the sale proceeds of your home may not be recognized as income allowing you to benefit from the tax exemption.
Let’s look at another example.
If you are a self-employed person and you have rendered services to a client for a fee, although you may not have invoiced your client and actually received the payment of your fees, you may have to “recognize” the services rendered as income.
If you had to recognize the services rendered as income even though you have not received any payment from your client, you may be required to pay taxes on the amount.
In the end, it’s important to look at your tax filings and liability with a tax professional, but you get the point.
Realized Income vs Realized Gains
What is the difference between a realized income and a realized gain?
A realized income is when you have earned and received any type of income, from any source, such as:
- Salary or wages
- Dividend income
- Interest income
- Rental income
- Business income
- Portfolio income
In other words, when you get paid either for your work or on your investments, you are realizing an income.
A realized gain is essentially a realized “profit”.
This means that you have purchased an asset of some kind and have sold it at a price higher than your original purchase price.
When you sell something from profit, you are effectively realizing gains.
The notion of realized gains is important as, depending on the nature of the gain, you may have to report some or all of the gains on your income tax report to pay taxes.
For example, if you purchase a real estate asset for investment and sell it for a profit, under the tax laws, you must report some of that gain on your income tax and pay taxes as capital gains.
However, if you sell your principal residence for a profit, you may benefit from a capital gains tax exemption.
Depending on the manner that you are generating a realized gain, you may have to then determine your tax liability on it for income tax purposes.
Realize Income Takeaways
So, there you have it folks!
What is realized income?
Essentially, to say realized income, you are saying taxable income.
The more you earn an income (realize income), the more you may have taxes to pay.
As a result, understanding the type of income you are realizing and how it may impact you from a tax perspective will allow you to make the best financial decisions.
Under the US tax laws, you need to have a good understanding of the realization of income.
Essentially, realization is the process of determining what income reported on your income tax report will be subject to taxation.
Income realization is different from income recognition.
Income recognition is the process of determining tax liability on a series of prerequisites to the manifestation of gains and losses.
Ultimately, you should consider your realized income as your taxable income.
What you need to do is to calculate all the income that you earn (whether through employment, business, investment, or other) to get to your total realized income.
Then, as a next step, you will then need to determine tax liability on the income that you earned.
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Define Realized Income
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