You are probably aware that, basically, all income is taxable. But did you know that there’s a difference in how certain types of income are taxed?
The IRS treats earned income and unearned income differently.
Knowing how each type of income is taxed can help you be strategic and prioritize certain incomes to reduce your tax liability. Of course, all income is good, but focusing on building an income that is taxed the least can maximize your income.
EARNED INCOME
Earned income is income that you earn by working for it.
HOW IT’S TAXED
On earned income you pay two types of taxes: Income Tax and Social Security/Medicare Tax. Social Security/Medicare taxes are also referred to as FICA or payroll taxes.
If you are an employee these taxes are withheld from your paycheck, and if you are self-employed you pay these taxes through “self-employment tax”.
The Social Security tax rate is 12.4%. Your employer will pay half and you pay half. Therefore, you will only see 6.2% withheld from your paycheck.
The Medicare tax rate is 2.9%. Again, your employer pays half of this tax, so your paycheck will show a 1.45% withholding.
If you are self-employed you pay the full 15.3% (Social Security 12.4% plus Medicare 2.9%). Before you get too upset about paying both the employee and employer side of FICA taxes. Self-employed individuals do get to deduct the employer-equivalent portion of your self-employment tax when figuring your adjusted gross income (AGI). So, if your self-employment tax amount is $600, you get an above-the-line deduction of $300.
WHY IT’S IMPORTANT
In order to contribute to an IRA, you typically must have earned income. One exception is with a spousal IRA. You can contribute on behalf of a non-working spouse, but you must have earned income to cover both contributions.
There are also certain tax credits that you can only qualify for if you have earned income, such as the Earned Income Tax Credit.
Social Security benefits can be affected by your earned income. If you begin collecting Social Security benefits before your full retirement age and have earned income higher than certain earnings limits your benefits may be reduced.
TYPES
Again, earned income is income that you earn from working. This includes:
- Wages
- Salaries
- Tips
- Bonuses
- Commissions
- Net earnings from self-employment
UNEARNED INCOME
Unearned income is income that you receive even if you don’t work for pay.
HOW IT’S TAXED
Unearned income is only subject to Income Tax. You do not have to pay any payroll taxes on unearned income.
Unearned income is included in the calculation of your adjusted gross income (AGI). Which is then used to determine your taxable income and your tax liability. Unearned income is mostly taxed at your marginal tax rate (i.e. the tax bracket you fall in).
However, there are certain types of unearned income that are taxed at a capital gains tax rate. The capital gains tax rate is a much lower rate, so you definitely want to pay taxes with this rate! Long-term capital gains and qualified dividends are taxed at this lower rate.
WHY IT’S IMPORTANT
Unearned income will not reduce your Social Security benefits like earned income will.
Maximizing unearned income, especially as you approach retirement age, will be beneficial for reducing your taxes and retaining more of your income.
TYPES
Again, unearned income is income that you collect other than from working. This includes:
- Taxable interest
- Ordinary dividends
- Capital gains distributions
- Unemployment compensation
- Taxable social security benefits
- Pensions
- Annuities
- Cancellation of debt
- Distributions of unearned income from a trust
Even if you hire a tax professional to file your annual tax return, it is still beneficial to be educated on tax-saving strategies. Follow along this tax season for more tax tips!
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