Income can be divided into two categories, earned income and unearned income. Earned income is any income you receive in exchange for your time. For example, paycheck income, freelance income, side-gig income, etc.
Unearned income, on the other hand, is not related to active work. Examples of unearned income include pensions, social security benefits, real estate income, unemployment compensation, and capital gains.
Unearned and earned income are taxed differently
Taxes on earned income is generally higher than unearned income because of taxes that are specific to it, payroll taxes.
Payroll taxes consists of social security and medicare taxes also known as FICA. You and your employer each pay 6.2% in social security tax and 1.45% in Medicare tax on all earnings.
For those who are self-employed, they must pay their social security taxes directly to the IRS for the entire 12.4% up to $137,7000 of earnings and 2.9% in Medicare tax.
Are you a fan of TV show Schitt’s Creek? There is an episode where Johnny Rose applies for unemployment after his business flops and he loses everything. When he goes to the unemployment office he learns that he doesn’t qualify because all of his income was earned while self-employed.
Let this be your FYI. Normally, those who are self-employed don’t qualify for unemployment. Unearned income has benefits over earned income. This type of income is usually independent of your job and paycheck. Unearned income is also tax differently and normally more favorably than earned income.
Here’s a breakdown of three types of income
Earned income or paycheck income is the most common type of income. Also known as active income, earned income is income that’s paid by an employer in exchange for your time or active work.
Any compensation received from working, for example, salaries, tips, and bonuses are all earned income. It requires an active output of energy. Work 40 hours a week? You will get paid for those hours.
Self-employment is also earned income. Independent contractors, consultants, and freelancers may not be paid for the amount of time worked. Instead, they might be paid for a service they provide, assignment, or upon completion of a project.
Earning an income is the way most of us have learned about making money. When you work, you get paid. However, there are some considerations to know about earned income. It’s potentially one of the highest-taxed sources of income.
The higher your salary the higher your taxes. Earned income is subject to federal income tax, medicare, and social security taxes. In places like New York City, we also are taxed at both the city and state levels.
Another downside of earned income is that we are capped by the number of hours in a day. If you are an hourly employee there are only 24 hours in a day. Even if you are paid by assignment or project, there are only but so many hours one can do active work.
But next, we’ll learn about passive or investment income.
The IRS defines unearned income as investment-type income such as taxable interest, ordinary dividends, and capital gain distributions.
Investment income normally requires upfront money or capital to get started. Stocks, bonds, real estate are examples of assets that produce investment income. Most investment income is earned passively.
Passive income requires little to no effort in order to continue to produce a return or profit.
Qualified dividends are paid by many U.S. stocks. A dividend is a portion of a company’s profits that are paid out to shareholders.
Qualified dividends are taxed 0%, 15, or 20% compared to earned income which ranges from 10% to 37% just in federal taxes. In addition to being taxed at a lower tax rate, investment income isn’t subject to payroll taxes.
There are certain circumstances where you don’t pay any taxes on capital gains. Capital gains is the profit of selling an asset for more than you paid for it.
Did you know that it’s possible to exclude up to $250,000 of capital gain from the sale of your primary residence? If you file a joint tax return with your spouse, that amount doubles! That is $500,000 of tax-free capital gains.
Personal income tax rates and corporate tax rates were about the same at the lower income levels until the 2017 Tax Cuts and Jobs Act. The corporate tax rate was reduced from 35% to a flat rate of 21%.
Self-employed folks can face personal tax rates between 10 to 37% plus the 15.3% they must cover in Medicare and Social Security taxes.
Income or profits from a business are taxed differently. Generally, any income we earn is taxed before we can use it for our living expenses. Business income is different.
Businesses have the ability to deduct expenses from their income before it’s taxed. They only pay tax on after-expense income. There are far more business write-offs then for the average taxpayer. Business owners are usually spending money on necessary expenses to keep a business running. The more money invested back into the business, the more tax deductions they’ll have.
Expenses that are tax-deductible are those that are necessary to run a business. Expenses such as equipment, cell phones, subscriptions to business-related information, even entertainment and travel qualify as write-offs.
At the lower income levels of income—$40,000 and $100,000—there is no appreciable difference between the taxes for individuals and those for corporations. However, at the higher level of $500,00, the corporate tax is almost twice the level of the personal tax.
Is unearned income better than earned income?
As long as income is earned ethically, I wouldn’t consider any income as “bad income.” However, it’s important to be aware of the advantages and disadvantages certain incomes have.
Paycheck income will be taxed between 10% and 37% in federal taxes alone. Add payroll taxes, state taxes, and city taxes, and your earned income could be taxed closed to 50%. When corporations have a capped tax rate at 21% while a paycheck employee can have their earnings taxed upwards of 50% it reeks of unfairness.
Even if the wealthy don’t own businesses they understand that investment income is taxed at a lower rate. The more they invest, the more that money grows. This is why the wealthy get wealthier.
Play the game
Let’s understand the tax game and let’s play! Most of us solely focus on increasing our earnings not understanding the ways we could improve our net worth and diversify our tax burdens.
Investments held for more than a year pay long-term capital gains taxes. Tax rates for long-term capital gains are 0%, 15, or 20%. Would you rather exchange your waking hours for money? Or would you rather be asleep and your money make you money?
Earned income is the most time consuming to earn. The key is to use earned income to leverage your paycheck into business or investment income. We have certain tax-advantaged accounts like the health savings account, Roth IRA, and other retirement accounts we can use.
Saving money isn’t enough to build wealth. If you are ready to take the first step to invest, check out this Investing for Beginners guide, and start building your investment income today. Don’t let overwhelm and decision fatigue stop you from gaining control of your finances.
- How to Invest: A Beginner’s Guide to Investing in the Stock Market
- Roth 401(k) vs. Traditional 401(k) | Similarities, Differences, and Examples
- How To Retire In Less Than 10 Years
- The Basics of F.I.R.E (Financial Independence Retire Early)