Your tax liability is based on your overall income, so it's important to understand the different types of income and how the Internal Revenue Service (IRS) treats them. Earned income and unearned income each include diverse forms of payments and they have unique tax implications.
Key Takeaways
- Earned income is what you receive from working. It includes wages, salaries, and self-employment income.
- Some tax breaks depend on you having at least some earned income. You can be disqualified from claiming them if you don’t.
- Unearned income is that which you don’t have to work for. Think interest and dividends from investments, alimony, and capital gains.
- Some unearned income is taxed at its own special rates that can be kinder than those applied to earned income.
Types of Earned Income
Earned income is what you earn from working or from disability payments. It includes:
- Wages
- Salaries
- Tips
- Net earnings from self-employment
- Union strike benefits
- Long-term disability benefits
- Nontaxable combat pay if you elect to have it treated as earned income
Why Earned Income Is Important
You must generally have earned income to make traditional IRA or Roth IRA contributions. The exception is a spousal IRA. You can contribute to this type of IRA on behalf of a non-working spouse if you have sufficient earned income to cover contributions to both.
You must have earned income to qualify for certain tax benefits, as well. They include the Earned Income Tax Credit, a special tax break for low- to moderate-income workers.
Your earned income in retirement can impact your Social Security benefits, depending on when you begin collecting. The Social Security earnings limit can reduce your benefits if you work and collect Social Security simultaneously before your full retirement age.
Note
One dollar will be deducted from your benefits for every $2 you earn over $19,560 in 2022 if you were under full retirement age. This limit increases to $21,240 in 2023.
Types of Unearned Income
Unearned income is money you receive other than from working. It includes:
- Annuity payments
- Pension income
- Distributions fromretirement accounts
- Capital gains
- Interest income
- Dividends
- Real estate income
- Alimony
- Unemployment compensation
- Taxable Social Security benefits
Unearned income doesn't qualify as compensation that you can contribute to an IRA, although alimony is an exception.
Important
Most but not all types of unearned income are ineligible for contribution to an IRA or a Roth IRA.
Taxes on Earned Income
You must pay two types of taxes on earned income: Social Security/Medicare taxes (called "FICA," "OASDI," or "payroll taxes") and income taxes. The payroll taxesthat are withheld from your paychecks have two components.
The Social Security Tax
First, 12.4% of your earned income is paid to Social Security. Your employer pays half this tax. You pay the other half.
Note
You pay the full 12.4% if you're self-employed, but the "employer" portion of 6.2% is tax deductible as an above-the-line adjustment to income.
The Social Security tax is payable on the amount of earned income you receive, up to a specified dollar limit called the"contribution and benefit base" or "earnings cap."This dollar limit is 147,000 in 2022 and increases $160,200 in 2023.
No additional Social Security payroll tax is owed on earned income in excess of this limit, at least not until Jan. 1 of the new year when you begin to earn annual income again. Then earnings begin accumulating toward the limit again.
The Medicare Tax
The second withholding amount is for the Medicare tax, which is 2.9% of all wages. Again, it's the joint responsibility of the employer and the employee with each paying1.45%, but you must pay the full 2.9% if you're self-employed.
The Medicare tax doesn't have an earnings cap. Any wages or other forms of earned incomeare subject to it.
Note
The Social Security tax has a wage base limit, but the Medicare tax does not. You may have to pay an additional Medicare tax if you're a high earner.
Taxes on Unearned Income
Unearned income isn't subject to Social Security or Medicare taxes, but it still contributes to your tax burden. It's included in the calculation of your adjusted gross income (AGI), your gross income minus certain above-the-line deductions.
Your AGI is used to calculate your tax liability. It also determines your eligibility for certain deductions and tax credits. You can find it on line 11 of the 2022 Form 1040 when you complete your federal tax return.
Most unearned income is taxed at your marginal tax rate. This is the percentage of tax you pay at each top tax bracket. But certain types of unearned income, such as capital gains and qualified dividends, are taxed at a lower rate.
Important
Unearned income is taxed differently from earned income, but it's not tax free.
Earned vs. Unearned Income
All income is good income, but you should be strategic about which you prioritize at different stages of your life to minimize your tax liability and maximize your income.
You might consider maximizing earned income sources if you're at an early stage in your career. This is a time when you can take advantage of tax breaks for retirement plan contributions. You want to grow your nest egg with the help of compounding returns over the years.
Pre-tax salary-deferral contributions made to retirement accounts, pension plans,or other pre-tax accounts will reduce your income tax liability in the contribution year, although they're subject to annual limits.
Note
Retirement plan contributions won't reduce your Social Security and Medicare taxes. These are taken out of gross wages.
You can make the transition to less earned income and more unearnedincome as you approach retirement age. Doing so will benefit you at a time when your goal will be to minimize taxes and draw a sustainable income.
Tax treatment will vary, depending on the type of unearned income you have. It's best to have money available from multiple sources. You'll want tax-free accounts like Roth IRAs and tax-deferred accounts like 401(k)s.
The Bottom Line
Some retirees do handiwork or become self-employed in some other way when they find themselves with time on their hands. Many are caught off guard by the Social Security and Medicare taxes they must pay on their newfound earned income, and they can get behind on tax payments.
Work with a trustworthy tax professional to help you calculate the correct amount of these taxes if you become self-employed. You can avoid surprises come Tax Day.
Frequently Asked Questions (FAQs)
What is the difference between earned and unearned income?
Earned income includes that which comes from employment: wages, tips, salaries, and net earnings from self-employment. Unearned income is any income that doesn't fit into these categories. It includes dividends, capital gains, pensions, and annuities. Think of it as income you directly work for versus income you don't work for.
Where is unearned income reported on your tax form?
You'll report unearned income on the IRS Form 1040. You may have to include Schedule 1 with your return and report it there as well. The total from Schedule 1 is then transferred to your Form 1040 tax return.
As a tax expert with years of experience navigating the intricacies of the U.S. tax system, I bring a wealth of knowledge to shed light on the concepts discussed in the article about tax liability based on overall income. Throughout my career, I've worked closely with individuals, guiding them through the complexities of earned and unearned income, taxation on various income types, and the implications for retirement planning.
Let's delve into the concepts presented in the article:
Types of Earned Income:
1. Wages: Compensation for hourly or salaried work. 2. Salaries: Fixed regular payments for employment. 3. Tips: Gratuities received in service-based industries. 4. Net earnings from self-employment: Profits from running one's own business. 5. Union strike benefits: Payments during a labor strike. 6. Long-term disability benefits: Income received due to a qualifying disability. 7. Nontaxable combat pay: Special compensation for military service.
Why Earned Income Is Important:
1. Traditional and Roth IRA Contributions: Typically require earned income, except for spousal IRAs. 2. Qualification for Tax Benefits: Earned income is often a prerequisite for certain tax breaks, including the Earned Income Tax Credit. 3. Social Security Benefits: Impact retirement benefits depending on earned income.
Types of Unearned Income:
1. Annuity payments: Regular payments from an investment. 2. Pension income: Retirement income from a former employer. 3. Distributions from retirement accounts: Withdrawals from tax-advantaged retirement savings. 4. Capital gains: Profits from the sale of investments. 5. Interest income: Earnings from interest-bearing accounts. 6. Dividends: Payments from shares of stock. 7. Real estate income: Rental or property-related income. 8. Alimony: Payments from a former spouse. 9. Unemployment compensation: Financial support during unemployment. 10. Taxable Social Security benefits: Social Security income subject to taxation.
Taxes on Earned Income:
1. Social Security Tax: 12.4% on earned income, up to a specified limit. 2. Medicare Tax: 2.9% on all wages, with no earnings cap.
Taxes on Unearned Income:
1. Not subject to Social Security or Medicare taxes. 2. Contributes to adjusted gross income (AGI): Used to calculate tax liability and eligibility for deductions and credits. 3. Most unearned income taxed at marginal tax rate: Exceptions for certain types, such as capital gains and qualified dividends.
Earned vs. Unearned Income:
1. Strategic Considerations: Strategic allocation based on life stages to minimize tax liability. 2. Retirement Planning: Transition to more unearned income in retirement for tax efficiency. 3. Variety of Income Sources: Utilize tax-free and tax-deferred accounts for financial flexibility.
The Bottom Line:
1. Retirement Considerations: Be mindful of Social Security and Medicare taxes in retirement. 2. Consultation with Tax Professional: Seek guidance from a trustworthy tax professional for accurate tax calculations and planning.
Frequently Asked Questions:
1. Difference between Earned and Unearned Income: Earned income is from employment, while unearned income includes dividends, capital gains, pensions, and annuities. 2. Reporting Unearned Income: Include on IRS Form 1040, possibly with Schedule 1.
As a seasoned professional, I recommend consulting with a tax expert to ensure accurate understanding and application of these concepts to individual financial situations.
