Taxation of Earned vs. Unearned Income

Here's what these two types of income include and how they are taxed

$20 dollar bill sitting on a tax return.
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Your income affects your tax liability, your ability to contribute to retirement accounts, and your Social Security benefits, so it's important to understand the different types of income and how the IRS treats them. The two types of income, earned and unearned income, each include diverse forms of payment and have unique tax implications.

Types of Earned Income

Earned income is money you earn from work or disability payments, including:

  • Wages
  • Salaries
  • Tips
  • Net earnings from self-employment income
  • Union strike benefits
  • Long-term disability benefits.
  • Nontaxable combat pay, if you elect to have included as earned income

In general, you must have earned income to make an IRA or Roth IRA contribution. The exception is a spousal IRA you contribute to on behalf of a non-working spouse. You must also have earned income to qualify for certain tax benefits, including the Earned Income Tax Credit, which is a special tax credit for low- to moderate-income workers.

Your earned income in retirement can also impact your Social Security benefits. If you work and collect Social Security early (before your full retirement age, which is based on your date of birth), and you have earned income, the Social Security earnings limit will apply that may reduce your benefits. If, for example, you're under the full retirement age during 2020, $1 will get deducted from your benefits for every $2 you earn over $18,240.

Varieties of Unearned Income

Unearned income, in contrast, is money other than that which you receive from work, including:

  • Annuity payments
  • Pension income
  • Distributions from retirement accounts
  • Capital gains
  • Interest income
  • Dividends
  • Real estate income
  • Alimony
  • Unemployment compensation
  • Taxable Social Security benefits

As a general rule, unearned income doesn't qualify as compensation you can contribute to an IRA. However, alimony is one type of unearned income that can you contribute to an IRA.

Most, but not all, types of unearned income are ineligible for contribution to an IRA or Roth IRA.

Taxes on Earned Income

You pay two main types of taxes on earned income: Social Security/Medicare taxes (called FICA, OASDI, or payroll taxes) and federal and state income taxes. The payroll taxes that are withheld from, or automatically taken out of, your paycheck have two components.

First, 12.4% of earned income is paid to Social Security. Your employer pays half of this tax, and you pay the other half. If you are self-employed, you pay the full 12.4%; however, the "employer" portion of 6.2% is generally tax deductible. This Social Security payroll tax is enforced on the amount of earned income that you receive up to a specified dollar limit, which is called the contribution and benefit base, or earnings cap. In 2020, this dollar limit is $137,700, up from $132,900 in 2019. No additional Social Security payroll tax is owed on earned income in excess of this limit.

The second withholding amount is for Medicare tax. This tax is 2.9% of all wages. Again, this tax is jointly the responsibility of the employer and the employee, with each paying 1.45%. But if you are self-employed, you pay the full 2.9%. Unlike the Social Security tax, this tax does not have an earnings cap; any wages or other forms of earned income are subject to the tax.

Although the Social Security tax has a wage base limit, the Medicare tax does not.

Unearned Income Taxation

Good news: This type of income isn't subject to payroll taxes. However unearned income sources still contribute to your tax burden as they are included in your calculation of Adjusted Gross Income (AGI), which is your income minus deductions. Your AGI is used to calculate your tax liability and determine your eligibility for certain deductions and credits. You can find it on line 37 of your 1040 tax form.

Most unearned income, such as interest income from CDs or savings accounts, IRA withdrawals, and pension payments, are taxed at your marginal tax rate, which is the percentage of tax you pay at each tax bracket. However, certain types of unearned income, such as capital gains and qualified dividends, are taxed at a lower rate.

While unearned income is taxed differently from earned income, it is not tax free.

Accumulating Earned vs. Unearned Income

While all income is good income, it's wise to be strategic about which income you prioritize at different stages of life to minimize your tax liability and maximize your income.

If you are at an early stage in your career, maximize earned income sources to qualify for contribution to retirement accounts and grow your nest egg with the help of compounding returns. Because payroll taxes will get taken out of earned income, also aim to secure at least a few sources of unearned income, which will be exempt from payroll taxes. In addition, any pre-tax salary deferral contribution made to a retirement account, pension plan, or another pre-tax account will reduce your federal and state income tax liability in the contribution year. However, it will not lower your payroll tax, which is taken out of gross wages. 

As you approach retirement, make the transition to less earned income and more unearned income. This approach will benefit you as a retiree, when your goal will be to minimize taxes and draw a sustainable income. Because tax treatment will vary depending on the income source, it is best to have money available from multiple sources, such as tax-free accounts like Roth IRAs, after-tax accounts like savings and investments in brokerage accounts, and tax-deferred accounts like IRAs and 401(k)s.

Some retirees start consulting businesses, do handiwork, or in some other way become self-employed. Many are caught off guard by the payroll taxes on their new-found earned income and can quickly get behind on tax payments. If you become self-employed, work with a trustworthy tax professional to help you calculate the right amount of payroll tax to pay; this way, there won't be any surprises come tax day.