Separating Unrealized from Realized Income: A Smart Strategy
Written on
Chapter 1: Understanding Income Types
Have you ever thought about the best way to keep oil and water apart? One clever solution is to put the oil on a boat! (I admit, that’s not my finest joke, but it does bring a smile.) Now, let’s transition to the world of personal finance. It’s crucial to ensure that your income is separated as distinctly as oil and water.
Why Is Income Separation Important?
Your approach to personal finance should lean towards conservatism. The last thing you want is to develop an unrealistic sense of security while evaluating your finances. Thus, you must categorize your personal income based on a pivotal question: Have you actually earned this income yet?
This leads us to two categories of income defined by this query:
- Unrealized Income: income that has not yet been earned.
- Realized or Cash Income: income that you have already earned.
This distinction is so significant that the IRS begins its tax assessment process here.
Unrealized Income Explained
Unrealized income, which refers to income you haven’t yet earned, often arises from investments. Any gains (or losses) from your investments remain unrealized until you decide to sell and receive cash.
While it can be exciting to see unrealized gains, there's a crucial downside: it’s not guaranteed. You can't rely on this type of income to materialize in your bank account.
Maintain awareness of your unrealized income (or losses), but remember to keep this income tracked separately until it transitions into cash that you can access.
Realized Income Defined
Realized income is the cash you’ve earned and have control over, generally from your primary job(s) or any withdrawals from your investments. This type of income is dependable; you know precisely what you’ve earned and what will appear in your bank account.
When evaluating your personal finances, it's wise to adopt a conservative mindset, and realized income serves as the most conservative measure of your overall earnings. Unlike investments, whose values can plummet, your paycheck is a guaranteed amount.
How to Effectively Separate Income Types
The separation process is straightforward: create two line items on your personal income statement. The first should represent your more conservative realized income, while the second indicates your unrealized income (or a blend of both).
It’s essential to track both types of income, but maintaining a clear distinction between realized and unrealized income is critical. Failing to do so may lead to overconfidence, which is one of the most detrimental feelings in personal finance.
Therefore, you must diligently monitor the cash you have earned, separate from the potential income you could receive.
Get Started on Income Separation!
Establish two lines on your personal income statement: the first for your realized income or any paychecks you receive from employment, and the second for your unrealized investment income. This practice helps you avoid spending money you cannot afford to lose by clearly knowing how much you can potentially lose.
If you found this information helpful, consider signing up for Medium through my referral link. (I receive a small commission if you do.)
For any inquiries or suggestions about personal finance topics, feel free to reach out at [email protected].
Chapter 2: Expert Insights on Taxation
In this insightful video, Warren Buffett discusses the critical issue of taxation, emphasizing that if other corporations paid their fair share, no one would owe "a dime" in federal taxes. This perspective sheds light on the broader implications of income distribution and tax responsibility.