Disclaimer: The statements made in this post are the opinion of the author. They should not be viewed as financial advice. Please consult with a financial specialist before making any financial decisions.
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Most people think of making money in only way way. You go to work, you get a paycheck. But there are actually two categories of income, and employment covers only part of one of them.
These categories are earned income and unearned income.
To put it simply, earned income is any money that you put in time to get while unearned income is money that you get without any additional effort on your part.
This might seem like a distinction that doesn’t need to be made.
So what if the money is earned or unearned? Who cares?
Well the IRS cares, and your retirement account cares, and you should to.
And to understand why you should care, I’ll highlight the differences between the two.
The Difference Between Earned Income and Unearned Income
Earned income and unearned income can be separated by asking three questions. What goes in to making money? How does that money grow? How is the income taxed?
1 What Goes In
The question “What goes in to making money?” is asking how involved you are throughout the money making process.
For earned income you are involved throughout. In the most basic form, hourly wages, the number of hours you put in is multiplied by your rate to determine the number of dollars you get out.
There are also salaried workers, project based compensation, per unit workers, and so forth. But the idea is that the more of you you put in the more you’ll get out.
Unearned income on the other hand is not dependent on you working, being present, or even awake. It is dependent on something else. That can be ownership, benefits, royalties, rents, and more.
For unearned income the factor that gives you more money is time passing not time put in. So the longer you wait the more money you’ll get, in general.
That doesn’t mean unearned income takes zero effort, some of it takes a lot of work, but your payment isn’t dependent on the hours you put in rather the value of what you get out of it.
2 How It Grows
The question, “How does your money grow?” has to do with what do you have to put in to get more of it.
Earned income is relatively stable. There are only two ways to grow earned income.
First, you can work longer hours. The more hours you work the more money you make. Simple as that. The problem with this strategy is that you only have 24 hours in a day and you do need to sleep.
Second, you can become more valuable. This can take the form of gaining more education, skills, experience, and so forth. the more valuable you become the more you will be paid for each hour you work.
Becoming more valuable is the preferred way to increase your earned income.
Unearned income is harder to pin down because it can swinging wildly depending on the type of unearned income. Royalties, for example, depend on the taste and preferences of the people. And there is little you can do to sway that.
But in general, time is what grows unearned income. The longer you wait the more you will have.
And the more time and/or money you put in upfront the more money you’ll pull out at the end.
In other words, unearned money compounds on what goes in.
3 How It Is Taxed
The question, “How is it taxed?” is probably the most important. It is what really makes unearned income so appealing.
Earned income is the most taxed thing in the United States. You are hit with FICA taxes for Social Security and Medicaid (7.65% for employees and double that for the self-employed), then you’re hit with federal income tax (ranging from 10%-37%), and you’re also potentially going to pay state taxes and other local taxes (as high as 4.4% on average in states like New York).
To put it another, the average American payed 29.8% of their income in taxes. That’s nearly 1 in every 3 dollars you earn!
Unearned income is much more nuanced that earned income though. If you make unearned income in the short term (usually less than a year) then you’ll probably end up paying at your regular tax rate.
But if you make unearned income in the long term your tax savings sky rocket. Your tax rate can even be as low as 0%! But the other rates of 15% and 20% are still less than earned income.
To put it another way, in the worst case scenario for long term capital gains (20%) you still save about $1 out of every 10 compared to the average earned income tax rate.
And that’s only one kind of income. Royalties are taxed at your regular income rate, but because they aren’t earned income you don’t pay that 7.65% FICA tax.
Rental income is the same as royalties, but you can deduct a ton of business expenses and do something called depreciation which increases your savings.
In other words, you are ALWAYS taxed more on earned income compared to unearned income.
Is Earned Income Worse Than Unearned Income?
While I’m sure that anybody reading this would love to have a bunch of unearned income, that doesn’t mean that earned income is worse than unearned income.
In fact, unless you receive a massive inheritance or win the lottery, you’ll probably need to use earned income to building you unearned income portfolio.
So that being said here is a comparison of the two.
- You can get earned income quickly, often paid within two weeks of working
- Earned income is reliable
- You can get loans more easier with earned income (employed income that is)
- Earned income qualifies you for Social Security
- Work helps give people purpose
- Tax savings
- Earn money while you sleep
- Can grow without effort
- Allows you to retire
- Can be passed on to children
- Higher taxes
- Must put in your time to get paid
- Only so much you can earn
- Can’t force it to grow
- Major tax issues if you do it wrong
Neither earned income or unearned income are better, but both serve a different purpose. Knowing the difference and knowing which income will serve you best is a key to successful personal finance.
What are some advantages or disadvantages I didn’t mention? Are you convinced that you need both? Tell me about it in the comments below.
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A list of definitions used on this blog can be found here.
Earned Income: Money earned as a direct result of putting time into work. This is for hourly, salaried, and commission based employees as well as self employed business owners who work in their business. It is subject to FICA taxes.
Unearned Income: Money that is earned through investment, royalties, rents, or other means that doesn’t require you to put in time or additional effort to make money. It is not subject to FICA taxes.