A Guide to U.S. Income Categories for Tax Planning

When it comes to tax planning, not all income is created equal.
Two people could both “earn” $100K a year and still end up paying very different amounts in federal and state taxes – simply because of what type of income it is.

At Princeton Asset, we think the first step to building a bulletproof tax strategy is to classify your income correctly.
Below we propose a master income category schema, designed for retirement planning, Roth conversion analysis, and other advanced tax strategies.

Why Classification Matters

Each income type interacts differently with the tax code:

Some are tax-free outright.
Some are taxable now but at reduced rates.
Some don’t just raise your tax bill – they can also cause other income to be taxed more heavily.

That’s why smart planners track income sources in separate buckets instead of lumping it all together.

The Master Income Categories

1. Principal – Zero Tax Income

Income that is not taxable at the federal level (and often at the state level) and generally does not count toward Adjusted Gross Income (AGI).
Examples:

Qualified Roth IRA or Roth 401(k) distributions (after age 59½ or 5-year rule)
After-tax contributions returned (such as basis in an IRA or non-qualified annuity)
Tax-exempt municipal bond interest*

*Note: Tax-exempt interest can still count toward MAGI for Social Security taxation and ACA subsidy calculations.

2. Special Unearned Income – Unique Rules Apply

Income that has special tax treatment or partial exemptions:

Social Security benefits
Railroad Retirement benefits (Tier 1 & Tier 2)
Workers’ Compensation benefits
Disability income (depending on who paid the premiums)
Veterans’ benefits (usually tax-free but relevant for income-based programs)

3. Unearned Income (Ordinary) – Taxed at Regular Rates

This is the default “ordinary income” bucket for most non-wage income:

Ordinary dividends
Taxable interest
Traditional IRA or 401(k) withdrawals
Pension payments (taxable portion)
Non-qualified annuity earnings portion
Short-term capital gains
Pass-through business income (S-corp, partnership, LLC)
Rental income (net of expenses)
Alimony received (pre-2019 divorce agreements)

4. Capital Gains Income – Preferential Rates

Taxed at reduced rates for most taxpayers, but with important subcategories:

Long-term capital gains (assets held > 1 year)
Qualified dividends (meet holding period & issuer requirements)
Collectibles gains (special 28% max rate)
Unrecaptured §1250 gain (real estate depreciation recapture at 25%)

5. Earned Income – Wages & Self-Employment

Income from active work, subject to payroll taxes:

W-2 wages (salary, bonuses, tips)
Self-employment / 1099 income
Guaranteed payments from partnerships
Certain taxable fringe benefits

6. Other Special Categories – Don’t Forget These

Foreign Earned Income (can be excluded under §911 or taxed with credits)
Scholarships & Fellowships (taxable portion if used for non-qualified expenses)
State tax refunds (taxable only if you itemized deductions in the prior year)
Cancellation of Debt income (unless excluded for insolvency, bankruptcy, etc.)
Gambling winnings (taxable, losses deductible only up to winnings)
Prizes & Awards (taxable at ordinary income rates)
Qualified Disaster Relief payments (generally tax-free)

Tax Impact Table

Here’s how each category interacts with key tax metrics:

Category	Federal Taxable?	Counts Toward AGI?	Counts Toward MAGI (SS)?	Counts Toward MAGI (ACA)?
Principal	No	Usually No	Sometimes	Sometimes
Special Unearned	Partially	Partially	Yes	Yes
Unearned (Ordinary)	Yes	Yes	Yes	Yes
Capital Gains	Yes	Yes	Yes	Yes
Earned	Yes	Yes	Yes	Yes
Other Special	Varies	Varies	Varies	Varies

The Bottom Line

If you want to optimize your tax bill – especially in retirement – you need to think beyond “how much income” and focus on “what type of income.”
By tracking your earnings in the right categories, you can:

Time withdrawals to stay in lower brackets
Avoid triggering extra taxes on Social Security
Manage ACA subsidies
Minimize capital gains tax

Tip: Financial planning software should not lump everything into “taxable income” without tracking these categories. That’s why at Princeton Asset, we model them separately for better accuracy and smarter decisions.

Disclaimer: This blog post is for informational purposes only and should not be considered financial advice. Consult with a qualified financial advisor for personalized guidance.