We admit filing taxes can be a gruesome task for most people. You work all year round to earn your money, but you have to pay your taxes and tell the IRS how much you earned, too. The twist is that even though income mainly comes from the money you earn from your job, income can also come from other sources such as awards, gifts, allowances, prizes, and investments.
But what if you didn’t earn any money from a job? Should you still pay taxes on income from other sources?
Understanding the differences between earned income and unearned unearned income is vital when it comes to your taxes. The way earned and unearned income are taxed can significantly affect your tax bill at the end of the year. How though? Let’s explore the difference.
What Is Earned Income?
Earned income is the income you receive in exchange for the work or service you provide. Basically, it is the income earned through your active involvement. Some examples of earned income include:
- Wages and salaries
- Self-employment income
- Tips and gratuities
- Union strike benefits
- Longterm disability benefits
- Non-taxable combat pay (if you choose to have it treated as earned income)
Reimbursements received from your employer for work-related travel expenses are also considered earned income. This might sound surprising, but alimony is also regarded as an earned income, as well as most foreign income and money earned through real estate.
Why Is Earned Income Important?
To make traditional IRA or Roth IRA contributions, you must have an earned income, except it’s a spousal IRA, which allows you to contribute to an IRA on behalf of your non-working spouse if you have enough earned income to cover the contribution for both your IRA and your spouse’s IRA.
Having an earned income also allows you to qualify for particular tax benefits, such as the Earned Income Tax Credit. In addition, your earned income can also affect your Social Security benefits, depending on when you start collecting. The Social Security earning limit can cut down your benefits if you work and collect Social Security before reaching full retirement age.
What’s The Tax Implication Of Earned Income?
- Income tax: Your earned income is subject to state and federal income taxes. However, the applicable tax rate may differ depending on your total income, tax credit, and deductions. Basically, the more you earn, the higher your tax rate might be.
- Payroll taxes: Your earned income is subject to payroll taxes, too. This includes social security and Medicare taxes. As an employee, you are required to have these taxes withheld from your paycheck. If you are self-employed, you must pay both the employer and employee portions.
- Credits and deductions: Individuals with earned income may also be eligible for several tax credits and tax deductions, such as the Earned Income Tax Credit, to reduce their overall tax liability.
What Is Unearned Income
Unlike earned income, unearned income or passive income is the money you make without performing a professional service or activity. Unearned income cannot be contributed to individual retirement accounts, with the exception of alimony. While most unearned income is not subject to payroll taxes, it still contributes to your tax bill.
Your unearned tax income is included in the calculation of your adjusted gross income (AGI), which is then used to calculate your tax liability and to determine your eligibility for certain tax credits and deductions. Tax rates may vary with unearned income sources.
Unearned income includes money-making sources such as:
- Interest and dividends
- Capital gains
- Rental income from passive activities
- Royalties
- Pension and annuities
- Social security benefits
What Is The Tax Implication Of Unearned Income?
- Income tax: While your unearned income is subject to both federal and state income, the rates and rules applied to unearned income are different from that of earned income. For example, if you had long-term capital gains, they may be taxed at a lower rate than your ordinary income.
- Investment taxes: Unearned income, such as dividends, can be subject to investment-related taxes. For example, the Net Investment Income Tax is applicable to specific unearned income sources such as capital gains, dividends, and interest if you fall into the higher income bracket.
- Payroll taxes: One great benefit of unearned income is the fact that it is not subject to payroll taxes such as Medicare and Social Security. However, this also means you won’t see payroll tax deductions on your passive or unearned income either.
- Tax credits and deductions: Although these credits and deductions are different forms of income available to individuals with earned income, your financial situation and the type of unearned income you receive go a long way in determining how many deductions and credits you are eligible for. Most unearned income is typically taxed at your marginal tax rate, which is the percentage of tax you pay at each top tax bracket.
Where Is Unearned Income Reported On Your Form?
You can report your unearned income on the IRS Form 1040; however, you may have to include Schedule 1 with your return and report it there, too. The total for Schedule 1 will then be transferred to your Form 1040 tax return.
Earned Income Vs. Unearned Income
As long as it doesn’t get you in trouble with the law, all income is good income. However, the trick to staying on top of your financial well-being is to minimize your tax liability and maximize your income.
Focus on growing your nest eggs with strategies such as compounding returns, pre-tax salary deferral contributions to retirement accounts, and pension plans. Consulting an expert tax strategist is one of your best shots at maximizing your income without getting into trouble with the IRS.
Looking for income-maximizing tax strategies? Book a free consultation call with our team today!
