Earned vs. Unearned Income Taxation

[DawgMan]

I was playing around with one of the online tax calculators to simulate projected tax scenarios, https://www.mortgagecalculator.org/calcs/1040-calculator.php. As I have always understood, wages qualify as earned income while IRA withdrawals go into the unearned category, which avoids payroll taxes. As an example, I ran a scenario showing only $300K of wages and compared that to $300K of only IRA distributions (no other income added in in these examples) and both showed the same exact Fed tax? Shouldn't the IRA distribution model show less taxes since payroll taxes are not in play??

 

[Dash man]

No, the calculator assumes W-2 income has already taken the payroll taxes out of your paycheck. There’s no tax deduction for payroll taxes.

 

[DawgMan]

No, the calculator assumes W-2 income has already taken the payroll taxes out of your paycheck. There’s no tax deduction for payroll taxes.

I’m not sure I’m understanding. Payroll taxes are an additional tax that hits your earned income (to a threshold), effectively adding to your total Fed tax on your return, correct? If my previous IRA contributions were already hit with the payroll tax, why upon taking IRA withdrawals (assuming $0 earned income) would my net Fed tax not be less than had I had the same amount in earned income? Perhaps I’m missing something simple here.

 

[euro]

Dashman is right, the payroll taxes were already taken out and are reported separately on the W2. So, you do pay more taxes on the earned income but the W2 already accounts for that.

 

[DawgMan]

Dashman is right, the payroll taxes were already taken out and are reported separately on the W2. So, you do pay more taxes on the earned income but the W2 already accounts for that.

Ok, I’m not where I can rerun some numbers now, but I am assuming you are suggesting Payroll taxes come out before so the calculator assumes they are addressed? If I run 1099 income vs W2 income on the calculator will it show the effective payroll tax, or will it assume it has already been addressed? I suppose what I was trying to visualize was the different true net available income based on different income types.

 

[Rianne]

That's interesting. I used this link:

https://www.irscalculators.com/tax-calculator

$100,000, no other income or deductions. MFJ
Gross income paid from work: Total taxes (Illinois state) $20,850.83
Self Employment: $24,524.05
tIRA distribution: $13,200.83

 

[Dash man]

Ok, I’m not where I can rerun some numbers now, but I am assuming you are suggesting Payroll taxes come out before so the calculator assumes they are addressed? If I run 1099 income vs W2 income on the calculator will it show the effective payroll tax, or will it assume it has already been addressed? I suppose what I was trying to visualize was the different true net available income based on different income types.

If you enter the income for Self Employed income, Schedule C or E, it will compute the payroll taxes.

 

[VanWinkle]

If you enter the earned income as business income, it will calculate the payroll taxes and the credit for 1/2 of those taxes as a credit. The IRA income will not initiate that calculation as there are no payroll taxes on IRA distributions. That has already been paid on the income before the contribution was made.

 

[cathy63]

There's no easy way to model this in most tax planners. Payroll taxes don't appear on your own tax return because the employer remits them, and the tax planners are just projecting what you'll see on your own 1040.

You could enter your earnings as self-employment income on Sched C. That will under-estimate your net income by a few $K because it will calculate that you are paying the employer's portion of payroll tax and then taking it as a deduction, but it's probably the closest you can get with a free calculator.

The most accurate way to do it would be to calculate the actual numbers that should be on a W-2 and then enter them into a program like TurboTax.

 

[cathy63]

If you enter the earned income as business income, it will calculate the payroll taxes and the credit for 1/2 of those taxes as a credit. The IRA income will not initiate that calculation as there are no payroll taxes on IRA distributions. That has already been paid on the income before the contribution was made.

I am pretty sure the 1/2 self-employment is a deduction, not a credit. I.e. if you pay $5K in self-employment taxes, you get to deduct $2500. If you're in the 35% bracket that saves you $875 in taxes.

 

[DawgMan]

There's no easy way to model this in most tax planners. Payroll taxes don't appear on your own tax return because the employer remits them, and the tax planners are just projecting what you'll see on your own 1040.

You could enter your earnings as self-employment income on Sched C. That will under-estimate your net income by a few $K because it will calculate that you are paying the employer's portion of payroll tax and then taking it as a deduction, but it's probably the closest you can get with a free calculator.

The most accurate way to do it would be to calculate the actual numbers that should be on a W-2 and then enter them into a program like TurboTax.

Yep. Just ran it as schedule C income and it does as you say so not 100% accurate. Oh well, was worth a try. As mentioned, I was running it more for illustration purposes but as a practical matter, do expect any real earned income going forward. Can I assume these calculators are helpful/more accurate when using unearned income types (i.e. interest/qualified/unqualified dividends), especially when modeling end of year Roth conversions? If there is a free one out there better than the one I used, would love to hear about it.

Thanks for all the feedback.