In the eyes of the IRS, your annual income has two different categories: earned income and unearned income. This is important because your money will be taxed at different rates depending on where it’s coming from. Sound confusing? Let’s break it down!
Tax Code Definitions: Earned and Unearned Income
When most taxpayers think of how to define their “income,” they’ll usually point to their annual W-2 tax form. The salaries, wages, service fees and tips that show up on employee W-2 forms are fairly easy to understand as “earned income.” But taxable scholarships and fellowship grants can also fall into the earned income category too.
On the other side of the equation is “unearned income.” This usually—though not always—will be recorded using 1099 tax forms. Items that fall under this classification include your annual capital gain distributions, ordinary dividends, and taxable interest. You’ll also report unearned income such as unemployment compensation, taxable social security benefits, distributions of unearned income from trusts, pensions and annuities with Form 1099.
Knowing how your various streams of income are taxed can help you navigate your tax planning and liability responsibly. For example, your earned income can be subject to tax rates of up to 37%. But your long- term capital gains and certain dividends will typically be held at lower tax rates that can max out at 20% instead. This is also why your timing for both “earned” and “unearned” income is important.
If you hold an investment for one year or less before selling, then that capital gain would be considered an unearned investment gain that the IRS will consider as part of your ordinary taxable income. Holding an investment for one year or more, however, can help ensure that you’ll only be taxed at long-term capital gains tax rates. There’s a lot to review, but working with someone familiar with the tax code can help you stay in the clear.
Limits for Unearned Income Tax Breaks
If the tax code were simple, it wouldn’t really matter how you receive income. But that’s just not the case. And if you aren’t sure of how your tax rates can fluctuate, then you may end up owing the IRS more than you bargained for.
Another example of how the tax code rates can fluctuate is the kiddie tax rules. For 2023, the amount of unearned income that can be taxed at the dependent’s income tax rate (which is usually lower) is $2,500. Amounts over that limit are held at the parent’s normal tax rate.
There is also a cap on the unearned income you may have in order to still qualify for certain tax credits and deductions. In the 2023 tax year, the Earned Income Tax Credit restricts that unearned income amount to $11,000. The idea here, in general, is to promote long-term investing with capital gains. But if you aren’t aware of what’s coming down the line for your taxes, then it’s all too easy to run into trouble when you’re getting ready to file your return.
Ready to Run the Numbers?
Partnering with an experienced financial advisor, as well as a tax preparer can help you get the answers you need for proper planning. If you’re based in the Indianapolis area and would like to meet in person, or virtually anywhere else in the country, please know that NSO & Company would be happy to help!
We’re proud to serve individuals, families, and small business owners with all of their tax planning needs. Let us know if you’d like to schedule a time to talk. Just call (317) 588-3131 to get started!
