Earned Income Is Taxed Differently Than Unearned Income
Earned income is the money you earn from working. It includes wages, salaries, tips, and net earnings from self-employment income. It also includes union strike benefits and some types of long-term disability benefits. With some types of deferred compensation plans, the payments are also considered a form of earned income.
Unearned income includes things like annuity payments, pension income, distributions from retirement accounts, capital gains, interest income, dividends, passive income generated from rental real estate, alimony, stock dividends, and bond interest. You must have earned income to make an IRA or Roth IRA contribution. This is why, once retired and no longer working, you can no longer contribute to your retirement accounts.
Earned income in retirement can also impact your Social Security benefits. If you collect Social Security early (before what is called your full retirement age which is based on your date of birth), and have too much-earned income, the Social Security earnings limit will apply and you may owe some of your benefits back. Earned income is taxed differently than unearned income.
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 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 half. If you are self-employed you'll 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 2017, this dollar limit is $127,200, up from $118,500 in 2016. This means that 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 employee and the employer, with each paying 1.45%. Unlike the Social Security tax which has an earnings cap, this tax does not. Any wages or other forms of earned income are considered subject to this tax. If self-employed, you pay the full 2.9%. These payroll taxes are used to fund Social Security benefits and Medicare benefits.
Unearned Income Taxation
Unearned income is not subject to payroll taxes. This is good news! However unearned income sources are included in your calculation of Adjusted Gross Income (AGI) for federal income tax purposes. You can find your AGI 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. However, certain types of unearned income, such as capital gains and qualified dividends are taxed at a lower rate.
If you can save a lot early on in life, you can build up sources of unearned income, and this income will be exempt from payroll taxes. This is good news for investors and for retirees. Any pre-tax salary deferral contribution made to a retirement account, pension plan, or other pre-tax contribution will lower the amount of federal and state income tax liabilities, however, they do not lower your payroll/FICA tax - the FICA tax has already been taken out of gross wages.
When you retire you will make a shift from relying on earned income to relying on unearned 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 handy-may work, or in some way become self-employed. Many are caught off guard by the payroll/FICA tax and can get behind on taxes once they become self-employed. If you become self-employed be sure to work with a good tax professional who can help you calculate the right amount of payroll tax to send - otherwise April 15th will be a very unpleasant time of year for you.