When it comes to filing taxes, the distinction between earned and unearned income is an important one ― especially to the IRS.
Defining Earned and Unearned Income
While the difference between earned and unearned income is an important one, it’s also fairly simple and to-the-point.
- Earned Income: Simply put, earned income is the money you make in exchange for the work you do. For most people, the vast majority of the money they make is considered earned income. Any money earned in professional wages or fees — including tips — counts as earned income. Additionally, true alimony is considered earned income, 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: Conversely, unearned income involves the money you make without having performed a professional service. The IRS views unearned income as those money-making sources involving interest, dividends, and capital gains. Additional forms of unearned income include retirement account distributions, unemployment compensation, Social Security benefits, and gambling winnings. Other forms of income, such as money that comes from an estate, trust, or partnership, may also be considered unearned income.
To recap, earned income comes from the work you do, while unearned income involves other money-making sources that do not involve an exchange of goods or services performed.
Income Types Impact 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. Together, Social Security and Medicare taxes fund the two federal programs whose name they bear.
The federal government deducts payroll taxes from your paycheck, and the earnings cap is set at $127,200 for 2017 (no additional Social Security is owed for earned income exceeding this cap). Of your earned income, 12.4% is paid to social security, with you splitting these costs fifty-fifty with your employer. Individuals who are self-employed are required to pay the full 12.4%, but half of that is tax-deductible in most instances.
Regarding Medicare tax, the government deducts 2.9% of all wages from each paycheck for this purpose. Again, employers and employees split this tax burden down the middle. Unlike with Social Security taxes, though, there is no earnings cap on the Medicare tax, and if you’re self-employed, you are still responsible for the full 2.9% without the possibility of a tax deduction.
Unlike earned income, the various forms of unearned income are not subject to payroll taxes. They are, however, included in your adjusted gross income (line 37 of your Form 1040) to satisfy federal tax requirements. Unearned income is usually taxed at your personal marginal rate, but there are a few instances (capital gains, qualified dividends, etc.) that will be taxed at a lower rate.
For more information regarding tax rates based on unearned income, please speak with a qualified tax representative, such as those at S.H. Block Tax Services.
Income Type Could Have Major Implications on Retirement Savings
Individuals who begin saving early for retirement are simultaneously accruing quality sources of unearned income, which is excluded from payroll taxes. Pre-tax salary deferral contributions (retirement, pension, etc.) lower income tax liabilities, and they will come in very handy once you retire and begin relying more on unearned income. However, the smartest approach is to diversify your unearned income sources (Roth IRAs, 401(k)s, etc.), as taxation varies according to each.
For those retired individuals who become self-employed, be sure to keep track of your personal payroll taxes to avoid any surprises come tax season!
Contact S.H. Block Tax Services Today!
While the basic difference between earned and unearned income is relatively straightforward, the more unearned income in your portfolio, the more complicated things get regarding taxation. If you are having difficulty keeping track of numerous sources of unearned income, please contact S.H. Block Tax Services to avoid making errors that could lead to substantial taxes and fees or even an audit performed by either the State of Maryland or the IRS.
You can reach the team at S.H. Block to schedule a free consultation by calling (410) 793-1231 or completing the form on this page. Together, we can work with you to diagnose any tax issues you might be having and begin constructing a plan to resolve these problems once and for all.
The content provided here is for informational purposes only and should not be construed as legal advice on any subject. Please read our full disclaimer here.