Types of Earned Income

Earned income is what you earn from working or from disability payments. It includes:

Wages Salaries Tips Net earnings from self-employment Union strike benefits Long-term disability benefits Nontaxable combat pay if you elect to have it treated as earned income

Why Earned Income Is Important

You must generally have earned income to make traditional IRA or Roth IRA contributions. The exception is a spousal IRA. You can contribute to this type of IRA on behalf of a non-working spouse if you have sufficient earned income to cover contributions to both. You must have earned income to qualify for certain tax benefits, as well. They include the Earned Income Tax Credit, a special tax break for low- to moderate-income workers. Your earned income in retirement can impact your Social Security benefits, depending on when you begin collecting. The Social Security earnings limit can reduce your benefits if you work and collect Social Security simultaneously before your full retirement age.

Types of Unearned Income

Unearned income is money you receive other than from working. It includes:

Annuity payments Pension income Distributions from retirement accounts Capital gains Interest income Dividends Real estate income Alimony Unemployment compensation Taxable Social Security benefits

Unearned income doesn’t qualify as compensation that you can contribute to an IRA, although alimony is an exception.

Taxes on Earned Income

You must pay two types of taxes on earned income: Social Security/Medicare taxes (called “FICA,” “OASDI,” or “payroll taxes”) and income taxes. The payroll taxes that are withheld from your paychecks have two components.

The Social Security Tax

First, 12.4% of your earned income is paid to Social Security. Your employer pays half this tax. You pay the other half.  The Social Security tax is payable on the amount of earned income you receive, up to a specified dollar limit called the “contribution and benefit base” or “earnings cap.” This dollar limit is 147,000 in 2022 and increases $160,200 in 2023. No additional Social Security payroll tax is owed on earned income in excess of this limit, at least not until Jan. 1 of the new year when you begin to earn annual income again. Then earnings begin accumulating toward the limit again.

The Medicare Tax

The second withholding amount is for the Medicare tax, which is 2.9% of all wages. Again, it’s the joint responsibility of the employer and the employee with each paying 1.45%, but you must pay the full 2.9% if you’re self-employed. The Medicare tax doesn’t have an earnings cap. Any wages or other forms of earned income are subject to it.

Taxes on Unearned Income

Unearned income isn’t subject to Social Security or Medicare taxes, but it still contributes to your tax burden. It’s included in the calculation of your adjusted gross income (AGI), your gross income minus certain above-the-line deductions. Your AGI is used to calculate your tax liability. It also determines your eligibility for certain deductions and tax credits. You can find it on line 11 of the 2022 Form 1040 when you complete your federal tax return. Most unearned income is taxed at your marginal tax rate. This is the percentage of tax you pay at each top tax bracket. But certain types of unearned income, such as capital gains and qualified dividends, are taxed at a lower rate.

Earned vs. Unearned Income

All income is good income, but you should be strategic about which you prioritize at different stages of your life to minimize your tax liability and maximize your income. You might consider maximizing earned income sources if you’re at an early stage in your career. This is a time when you can take advantage of tax breaks for retirement plan contributions. You want to grow your nest egg with the help of compounding returns over the years. Pre-tax salary-deferral contributions made to retirement accounts, pension plans, or other pre-tax accounts will reduce your income tax liability in the contribution year, although they’re subject to annual limits. You can make the transition to less earned income and more unearned income as you approach retirement age. Doing so will benefit you at a time when your goal will be to minimize taxes and draw a sustainable income. Tax treatment will vary, depending on the type of unearned income you have. It’s best to have money available from multiple sources. You’ll want tax-free accounts like Roth IRAs and tax-deferred accounts like 401(k)s.

The Bottom Line

Some retirees do handiwork or become self-employed in some other way when they find themselves with time on their hands. Many are caught off guard by the Social Security and Medicare taxes they must pay on their newfound earned income, and they can get behind on tax payments. Work with a trustworthy tax professional to help you calculate the correct amount of these taxes if you become self-employed. You can avoid surprises come Tax Day.