Understanding Realized Income

If you’ve been investing a while or are just getting started, chances are you’ve come across the term realized income. What exactly is Realized Income? That’s what we’re going to discuss here!

Realized income is the summation of all income that is actually received when earned and consists of all income from sales, work, services, and investments that have been sold or cashed out. Rental income, stock sales, paychecks, and side hustle profits are examples of realized income.

Where people tend to get confused is when they start comparing realized income with another term. Common terms that are being mixed up are realized and unrealized income as well as realized income vs recognized income. By the time you finish reading this, you should have a very firm understanding of how realized income is calculated as well as why it’s important to reduce your realized income if you want to build wealth!

What is Realized Income?

As stated earlier, realized income is income that is included in your taxable income and consists of all income that you’ve received for goods, services, wages, and sales.

For example, Luke owns a Land Speeder Shop near the local cantina. He sells speeders and has accrued $45,000 in sales. He also rents land speeders for local tour routes for $50/hour and has made about $30,000 in rental fees. On top of that, he fixes land speeders and had made a healthy side hustle out of this in which he makes $5,000.

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He is an avid investor and has stock in 3 of the largest land speeder manufacturing companies on this side of the galaxy. His investments were all purchased 2 years ago for $60,000 and have increased in value to $75,000.

What’s his realized income? Well, let’s add up all the income he actually received!

Luke’s Land Speeder Business

What about the money he made from stocks though? He also made $15,000 in stock appreciation right?

Not quite! Since he hasn’t sold the stock, appreciation is considered unrealized income. In fact, it’s considered unrealized gains to be more technically accurate. Had he sold the shares at their peak, he would have had realized gains of $15,000 which would be included as income.

Since Luke just holds the shares and they continue to fluctuate in value, they are considered unrealized gains and do not get counted as realized income.

Realized Income Vs Unrealized Income

As you saw in the example with Luke, realized income is income that can be considered tangible. It’s money that has actually been received. Unrealized income is income that generally comes from appreciation or the promise of profitability later. We covered how unrealized gains are considered appreciation of stocks that are possessed but not sold.

equity as unrealized gains

Another great example of unrealized income is in your home value. If you bought a home for $200,000 and it is now worth $275,000, you have an unrealized value of $75,000 known as equity. If you sell your home, you’ll have a realized income after you receive the profits from the sale.

However, it’s another story of how much money you actually walk away with after fees and taxes.

Realized Income vs Recognized Income

Now that you know how realized income differs from unrealized income, let’s explain how it differs from recognized income.

Realized Income is often mislabeled as recognized income and the terms are used interchangeably. There is one specific difference though and it’s a subtle one at that.

When we do taxes, recognized income is the amount of income that owe taxes on. Generally, when income is realized, it may not necessarily be recognized. This distinction can save us, taxpayers, a lot of money.

For example, let’s say we sold 100 shares of stock for $5/share. That would be an income of $500. The realized income is the amount that you made from the sale minus commission fees. If you spent $5 in brokerage fees, the realized gain is $495.

Let’s find out how much you would actually owe taxes on. Let’s say you bought the stocks for $4 per share. That means you only actually made $100 from the stock sale minus the $5 brokerage fee. Your recognized income is only $95. Instead of paying taxes on the entire $500 sale.

Another example of realized vs recognized income can be shown with Retirement Accounts. If you have a Roth IRA and are at least 59 1/2, you can withdraw your funds. If you withdraw $1000 a month, that $1000 is realized income but it’s not recognized because of the tax advantages of a Roth Account.

The investment being withdrawn was pre-taxed prior to investing and does not count as taxable income when it is withdrawn.

Benefits to Reducing Realized Income

One of the most important things to consider with realized income is when it benefits you to realize income and maybe not realize income. When the tax man comes around, you want to pay as little as possible. Am I right?

One of the first things to look at is what your tax bracket is. Depending on how much realized income you have for a given year will determine how much is recognized for the sake of taxes.

Cashing in investments may raise you into another tax bracket and force you to pay higher tax amounts if your recognized income bumps you into a new bracket. One way to use this in your favor though is to withdraw investments that have done poorly and taking advantage of negative realized income.

If you lost money in stocks, the losses can then be realized and recognized and lower your taxes. By doing this, you can even lower your income enough to prevent paying taxes from a higher bracket.

I’m not saying you should avoid taxes! I’m saying you may use losses in your favor to reduce how much you actually owe in taxes. Sometimes knowing how to manage your realized income can save you money and that’s just smart business.

Final Thoughts

Hopefully, this gives you a complete picture of the importance of understanding what realized income is. You should now know how to define realized income as well as recognize how it differs from unrealized and recognized income.

Another takeaway I hope you were able to grab was how managing your realized income can actually save you money in taxes.

If you have other questions or comments, feel free to leave them below! If you’d like to learn how to start investing in stocks for the first time, I’d love you to read our comprehensive primer. Until next time, let’s start investing!

Eric Baglio

Eric Baglio has been investing for over ten years and learned a lot of valuable lessons along the way. He has helped numerous people start investing on their own and founded Let's Start Investing to help anyone willing to learn how to build wealth. His favorite brokerage is Webull and his favorite stock advising service is Motley Fool Stock Advisor.

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