When it comes to filing taxes, the distinction between earned and unearned income might seem like a minor one. However, the IRS doesn’t think so, and if you mix up earned and unearned income on your tax returns or forget income sources of either type, you could end up with a lot of tax problems on your hands.
Defining Earned Income and Unearned Income
Every taxpayer should know the difference between earned and unearned income. The distinction isn’t too complicated, but it’s very important for your taxes.
- Earned income is the money you make in exchange for the work you do. For most people, almost all the money they make is earned income. Any money earned in professional wages or fees — including tips — counts as earned income. Reimbursements from your employer for travel expenses, including meals, accommodations, and transportation, also count as earned income. True alimony is considered earned income as well, as is most foreign income or money earned through real estate holdings (although you might want to speak with an experienced tax representative if you aren’t sure about whether different money streams count as earned income).
- Unearned income involves the money you make without having performed a professional service. Unearned income includes money-making sources that involve interest, dividends, and capital gains. Additional forms of unearned income include retirement account distributions, annuities, unemployment compensation, Social Security benefits, and gambling winnings. Other forms of income, such as money from an estate, trust, or partnership, may also be considered unearned income.
You don’t necessarily have to memorize every type of income and which category it falls into. Just remember: if you sold goods or provided labor, the money you made is earned income. If you have investment income or other sources of income that don’t involve any work or services, that money is unearned income.
How Income Types Affect Your Taxes
United States residents pay two primary taxes on earned income: payroll taxes (including Social Security and Medicare taxes) and federal and state income taxes. Social Security and Medicare taxes fund the two federal programs whose names they bear.
The federal government deducts payroll taxes from your paycheck, and the earnings cap is set at $137,700 for 2020 (which means you won’t owe any additional Social Security taxes after you exceed this cap). An amount equal to 12.4% of your earned income goes toward Social Security, but your employer splits this tax with you 50-50, so you only pay 6.2% in practice. (Self-employed people must pay the full 12.4%, but half the amount is tax-deductible in most instances.)
Medicare works somewhat like Social Security taxes: you and your employer split the tax bill, and each owes taxes equal to 1.45% of your income, for a total of 2.9%. However, unlike with Social Security taxes, there is no earnings cap on Medicare taxes. You must also pay the full 2.9% on any self-employment income, and you can’t take tax deductions to offset that amount.
Unearned income works differently than earned income. You don’t have to pay any payroll taxes, including Social Security and Medicare, on the various forms of unearned income. However, your unearned income (line 37 of your Form 1040) will count toward your adjusted gross income on your state and federal tax returns.
Usually, you’ll pay taxes on unearned income at your personal marginal tax rate; however, in certain cases (for example, capital gains and qualified dividends), your unearned income will be taxed at a lower rate. Some unearned income gets taxed at a much lower rate. For example, tax on long-term capital gains is zero if you earn less than $39,376 and only 15 percent if you earn between $39,376 and $434,550.
Income Type Can Have Major Implications on Retirement Savings
If you start saving early for retirement, you’ll end up accruing quality sources of unearned income, which is exempt from payroll taxes. Pre-tax salary deferral contributions to your retirement account or pension can lower your income tax liabilities, so these contributions will come in very handy once you retire and begin relying more on unearned income. In some cases, you may want to diversify your unearned income sources among options like Roth IRAs and traditional 401(k)s so you can combine the various tax benefits.
Also, if you’ve retired from working for others and are now self-employed, make sure to keep track of your personal payroll taxes to avoid any surprises come tax season.
Need Help With Unearned Income or Other Tax Issues? Contact S.H. Block Tax Services Today
The more unearned income you have in your portfolio, the more complicated your taxes can get. If you’re struggling to track your various sources of unearned income, contact S.H. Block Tax Services. We can help you avoid errors that could lead to substantial taxes and fees or even an audit.
You can reach the team at S.H. Block and schedule your free consultation by calling (410) 872-8376 or using the quick contact form on this page. Together, we can work with you to diagnose any tax issues and create a plan to resolve these problems once and for all.
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