Taxation of Earned vs. Unearned Income

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

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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. 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 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 types of contributions.

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.

Important

The American Rescue Plan expanded eligibility for the Earned Income Tax Credit in response to the COVID-19 pandemic in 2021, even to households whose income did not qualify in previous years. This includes more childless households, as well as taxpayers under age 25 and over age 65.

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.

For example, $1 would be deducted from your benefits for every $2 you earned over $18,960 if you were under the full retirement age during 2021. This threshold increases to $19,560 in 2022.

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
  • 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 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. 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 was $142,800 in 2021 and is $147,000 in 2022.

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. Then earnings begin accumulating toward the limit again.

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 paying 1.45%, 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 income are subject to it.

Note

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. 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 your 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

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 unearned income as you approach retirement. 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 payroll taxes on their newfound earned income. 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. 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 these categories. It includes dividends, capital gains, pensions, and annuities. Think of it as income you directly work for vs. income you don't work for.

Where is unearned income reported on your tax form?

You'll report unearned income on lines 2 through 8 on the 2021 IRS Form 1040 that you'll file in 2022. You may have to include Schedule 1 with your return.

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