Earned and Unearned Income
Two people each get $\$5{,}000$ this year. Ava earned it by working shifts at a grocery store. Ben earned it when a stock he bought years ago went up in value and he sold it. Do they owe the same tax? Not quite, and the reason shows up in this page. By the end, you'll be able to explain why.
Earned vs. unearned income
Earned income is money you get in exchange for working: wages, salary, tips, commissions, and bonuses. If you stop working, it stops.
Unearned income is money your money (or your property) makes for you. You don't have to work for it each day. The main kinds are interest, dividends, and capital gains.
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Interest: what a bank pays you for keeping money in a savings account, or what a bond pays.
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Dividends: a share of a company's profit paid to people who own its stock.
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Capital gain: the profit when you sell an asset (like stock) for more than you paid. Capital gain = selling price − purchase price.
Classify each item as earned or unearned income: (a) wages from a part-time job; (b) interest on a savings account; (c) dividends from shares of stock; (d) a sales…
Classify each item as earned or unearned income:
(a) wages from a part-time job;
(b) interest on a savings account;
(c) dividends from shares of stock;
(d) a sales commission;
(e) a profit from selling shares for more than you paid.
Ethan keeps $\$2{,}000$ in a savings account that pays 3% interest per year. Calculate the interest he earns in one year. Is this earned or unearned income, and why?
Ethan keeps $\$2{,}000$ in a savings account that pays 3% interest per year. Calculate the interest he earns in one year. Is this earned or unearned income, and why?
Capital gains and holding periods
The tax on a capital gain depends on how long you held the asset:
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Short-term gain: held one year or less. It is taxed at your ordinary income tax rate.
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Long-term gain: held more than one year. It is usually taxed at a lower rate.
Now see why it matters. Say a gain is $\$1{,}000$. Your ordinary rate is 22%, and the long-term rate is 15%.
| Held | Rate | Tax | You keep |
|---|---|---|---|
| 10 months (short-term) | 22% | $\$220$ |
$\$780$ |
| 13 months (long-term) | 15% | $\$150$ |
$\$850$ |
Waiting a few extra months saved $\$70$ on the same gain.
Mia bought a stock for $\$1{,}000$ and sold it for $\$1{,}400$ after 8 months. Calculate her capital gain. Is it a short-term or a long-term gain? (Short-term means held…
Mia bought a stock for $\$1{,}000$ and sold it for $\$1{,}400$ after 8 months. Calculate her capital gain. Is it a short-term or a long-term gain? (Short-term means held one year or less.)
Isabella bought stock for $\$2{,}000$ and sold it for $\$3{,}200$. If she sells after 10 months, the gain is taxed at her ordinary rate of 22%. If she sells after 13…
Isabella bought stock for $\$2{,}000$ and sold it for $\$3{,}200$. If she sells after 10 months, the gain is taxed at her ordinary rate of 22%. If she sells after 13 months, it is taxed at a long-term rate of 15%.
(a) Calculate the gain.
(b) Calculate the tax in each case.
(c) Calculate the difference, and explain what this teaches about holding periods.
Comparing taxes on different income
To compare fairly, find the effective tax rate:
$$\text{effective rate} = \frac{\text{total tax}}{\text{income}} \times 100\%$$Wages usually owe two taxes: federal income tax and FICA (7.65% for the employee: Social Security plus Medicare). Unearned income like interest is taxed at your ordinary rate. Qualified dividends and long-term gains get lower rates, and generally don't owe FICA.
Ava has the lower income tax rate (12% vs. 15%), but a higher effective rate because of FICA. That is the answer to our opening question.
After-tax income = income − tax. For dividends, compute the dividend income first: shares × dividend per share.
Ava earns $\$5{,}000$ in wages. Her federal income tax rate is 12%, and she also pays 7.65% FICA. Ben has a $\$5{,}000$ long-term capital gain, taxed at 15% (assume no…
Ava earns $\$5{,}000$ in wages. Her federal income tax rate is 12%, and she also pays 7.65% FICA. Ben has a $\$5{,}000$ long-term capital gain, taxed at 15% (assume no other taxes).
(a) Calculate the total tax for Ava and for Ben.
(b) Compare the effective rates.
(c) Explain one reason for lower rates on long-term gains and one criticism.
Olivia owns 150 shares of a company that pays a dividend of $\$3…
Olivia owns 150 shares of a company that pays a dividend of $\$3$ per share per year. Assume qualified dividends are taxed at 15%, and bank interest is taxed at her ordinary rate of 22%.
(a) Calculate her yearly dividend income.
(b) Calculate the tax if that same dollar amount were bank interest, and the tax as dividends.
(c) Calculate the after-tax amount in each case.
Is the difference fair?
The rates in this page are illustrative, not official. Real rates change and depend on your income. The pattern, though, is real: long-term gains and qualified dividends are often taxed less than wages.
Reasons people give for lower rates:
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It encourages people to invest, which helps companies grow and hire.
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The profit may build up over years, and inflation makes part of the "gain" not a real gain.
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It rewards patience instead of quick trading.
Criticisms:
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Wages owe FICA, but investment income usually doesn't, so a worker can face a higher effective rate.
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People with more wealth get more of their income from investments, so they benefit most.
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It treats money from owning something more gently than money from working.
When you argue about fairness, use numbers (effective rates) and give one reason on each side.
Daniel has these amounts for the year: wages: $\$40{,}000$; bank interest: $\$300$; qualified dividends: $\$500$; long-term capital gains: $\$1{,}500$. Assume wages and…
Daniel has these amounts for the year:
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wages:
$\$40{,}000$; -
bank interest:
$\$300$; -
qualified dividends:
$\$500$; -
long-term capital gains:
$\$1{,}500$.
Assume wages and interest are taxed at 12% (ignore deductions). Wages also owe 7.65% FICA. Dividends and long-term gains are taxed at 15%.
(a) Calculate his earned income, unearned income, and total income.
(b) Calculate the tax on each category and the total tax.
(c) Calculate the effective tax rate on his wages (with FICA) and on his unearned income.
(d) Argue whether it is fair that unearned income can face a lower rate than wages.
Two investors each make a $\$4{,}000…
Two investors each make a $\$4{,}000$ gain on a stock. Investor X sold after 11 months, and the gain is taxed at 24%. Investor Y sold after 14 months, and the gain is taxed at 15%.
(a) Calculate the tax and after-tax gain for each investor.
(b) Calculate the difference in after-tax gain.
(c) Evaluate how the tax system rewards long-term investing, and explain a reason some people say wages, which also owe FICA, are treated less favorably than capital gains.
Summary
Back to the start: Ava and Ben each got $\$5{,}000$, but Ava's wages owed income tax and FICA, so she paid $\$232.50$ more than Ben.