This is our second article that we are doing on "How Is My Income Taxed?". Understanding how different types of income are taxed can be confusing and it is something we see pop up in our Free Facebook Group and Tax Minimization Program all the time.

If you haven't checked out our first article, What Is Ordinary Income Tax vs Capital Gain Tax?, check it out now!

There are three main types of income that we want to focus on:

• Earned Income
• Passive Income
• Portfolio and Non-Taxable Income

Today we are going to be focused on earned income. 

What Is Earned Income?

Per the IRS, earned income includes all the taxable income and wages you get from working for someone else, yourself or from a business or farm you own.

Basically earned income is a direct result of the work or service you do or in other words, income from your "day job". This is typically income from activities that are you actively participating in. With this type of income you are either an employee or self-employed.

Typically you see this in the form of wages or salary (Form W2) or small business income including contractor and gig work (Form 1099 and Reported on Schedule C). 

Examples of earned income include: wages, salaries, tips, commissions, business income (minus expenses), gig work, freelance work, etc.

Earned income does NOT include: interest and dividends, pensions and annuities, social security, child support, unemployment benefits, or alimony.

How Is Earned Income Taxed?

The unfortunate part about earned income is that it is often subject to high taxes when compared to other income types. There are a couple ways earned income is taxed:

• FICA Taxes (Employee)
  • Social Security: 6.2% (Up to $147,000 for 2022) - Your employer also covers this same amount for you.
  • Medicare: 1.45% (Add 0.9% if over $200k Single or $250k Married) - Your employer also covers this same amount for you.
• Self Employment Taxes (Sole Proprietor, Single Member LLC, Partnership, etc) 
  • Social Security: 12.4% (Up to $159,177 for 2022)
  • Medicare: 2.9% (Add 0.9% if over $200k Single or $250k Married)
• Ordinary Income Tax Rates
  
  • This us just your normal income tax using the tax brackets (10%, 12%, 22%, 24%, 32%, 35%, and 37%). 
  • Check out our article here for more on ordinary income tax rates.

As an example, if you are an employee working for someone you would pay both FICA taxes on your income along with your ordinary income tax rates.

If you are self-employed operating as a sole proprietor you will pay both self employment taxes on your income along with your ordinary income tax rates.

How Is S Corporation Income Taxed?

You'll notice that when we talked about being self-employed above we didn't talk about S Corps (just sole props, single member LLCs, etc.) First as we know, with an S Corp you have both payroll (reasonable salary) and distributions/dividends.

Payroll of course would be considered earned income. On the payroll portion you as an employEE of your own business will pay FICA taxes and then you as an employER will match that FICA tax. Essentially this is equal to self employment taxes. You will also pay your ordinary income tax rate on your salary.

Now here is where things get a little funky, the income from your S Corporation (via K1) that you report on your personal return is technically not considered earned income but rather "non-passive" income. This is of course assuming you actively participate in the S Corp.

Now here is the benefits of the S Corporation. FICA taxes aka "self employment taxes" stop at your salary and the remaining income from the S Corporation is simply taxed at your ordinary income tax rates and you avoid self employment taxes on it. 

To learn more about S Corporations check out our previous articles and series:

What Is An S Corp?

When Should I (or Should I Not) Become An S Corp?

Everything You Need To Know About S Corporations Series

What Is The Good Thing About Self Employment Income (or Non Passive S Corp Income)?

You might be thinking, why would I ever want to have "earned income" if it's taxed at some of the highest rates and that is a valid question. In a perfect world we would not have any "earned income" but ultimately unless you landed in an extremely wealthy family, you have to create your own wealth somehow and that will almost always start with earned income.

That is often why we say earned income should be used to build wealth but once you have wealth you should look to shift income into passive and portfolio income to help minimize your tax hit. We will be talking about both of those in the coming weeks.

With that being said, the good thing about both self employment and S Corp income is that you can utilize the tax code to take deductions (write-offs) to help offset your income. 

You can offset your business income with allowed business expenses like maximizing deductions (meals, automobile, travel etc), hiring your kids, utilizing retirement accounts, depreciation and so much more that we discuss on both our Small Business Tax Savings Podcast and dive even deeper into on our Tax Minimization Program.

Earned Income - Summary

• Ordinary income tax is just the typical marginal tax rates.
• Earned income is subject to FICA taxes (if you are an employEE) or self employment taxes (if you are self employed) PLUS ordinary income tax rates.
• Utilizing an S Corp is a potentially great strategy for the self employed to minimize the amount of self-employment taxes they get hit with.
• Ordinary income or earned income cannot be offset by passive losses. If you are unsure what "passive" means, we will be talking about that next week.
• Earned income is often the highest taxed income you will experience.
• The great thing about self employment and S Corp income is that you can utilize the tax code in your favor to take advantage of every possible business deduction available.

As always if you are looking at how to lower your taxes, check out our Tax Minimization Program where we deep dive into strategies to ensure you're paying the least amount in taxes as legally possible while giving you access to our team for those questions that pop up along the journey!