Taxation of Earned vs. Unearned Income
Here's what these two types of income include and how they're taxed
Your tax liability is based on your overall income, so it's important to understand the different types of income and how the IRS treats them. Earned income and unearned income each include diverse forms of payments and have unique tax implications.
Types of Earned Income
Earned income is that which you earn from working or from disability payments. It includes:
- 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 IRA or Roth IRA contributions. The exception is a spousal IRA that you can contribute to on behalf of a non-working spouse. You must also have earned income to cover both contributions.
You must also have earned income to qualify for certain tax benefits, such as 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 because you'd have earned income.
For example, $1 would be deducted from your benefits for every $2 you earned over $18,240 and you were under the full retirement age during 2020. The deductions begin with earnings over $18,960 in 2021 if you haven't yet reached your full retirement age.
Types of Unearned Income
Unearned income is money you receive other than from working. It includes:
- Annuity payments
- Pension income
- Distributions from retirement accounts
- Capital gains
- Interest income
- Real estate income
- Unemployment compensation
- Taxable Social Security benefits
As a general rule, unearned income doesn't qualify as compensation that you can contribute to an IRA, although alimony is an exception.
Most, but not all, types of unearned income are ineligible for contribution to an IRA or 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 taxes that are withheld from your paychecks have two components.
First, 12.4% of your earned income is paid to Social Security. Your employer pays half this tax, and you pay the other half. 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 $142,800 in 2021. No additional Social Security payroll tax is owed on earned income in excess of this limit, at least not until January 1 of the new year rolls around when earnings begin accumulating toward the limit again.
The second withholding amount is for the Medicare tax. This is 2.9% of all wages. Again, it's the joint responsibility of the employer and the employee, with each paying 1.45%, but you must pay the full 2.9% if you're self-employed. Unlike the Social Security tax, this Medicare tax doesn't have an earnings cap. Any wages or other forms of earned income are subject to it.
The Social Security tax has a wage base limit, but the Medicare tax does not.
Taxes on Unearned Income
Unearned income isn't subject to payroll taxes, but it still contributes to your tax burden because 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 and to determine your eligibility for certain deductions and credits. You can find it on line 11 of your 2020 Form 1040 when you complete your return.
Most unearned income is taxed at your marginal tax rate, the percentage of tax you pay at each tax bracket. But certain types of unearned income, such as capital gains and qualified dividends, are taxed at a lower rate.
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 considering maximizing earned income sources if you're at an early stage in your career, when you can take advantage of tax breaks for retirement plan contributions and grow your nest egg with the help of compounding returns over the years. Any pre-tax salary deferral contribution made to a retirement account, pension plan, or another pre-tax account will reduce your income tax liability in the contribution year.
Contributions won't reduce your Social Security and Medicare taxes, however, which are taken out of gross wages.
Then you can make the transition to less earned income and more unearned income as you approach retirement. This will benefit you as a retiree when your goal will be to minimize taxes and draw a sustainable income. Tax treatment will vary depending on the type of unearned income, so it's best to have money available from multiple sources, such as 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 payroll taxes on their newfound earned income and they can get behind on tax payments. Work with a trustworthy tax professional to help you calculate the right amount of payroll tax if you become self-employed so there won't be any surprises come tax day.