Exercises: Earned and Unearned Income

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.

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.)

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?

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 $\$3$ 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.

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.

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 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 $\$4{,}000$ 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.