Working Sucks (For Income Tax Reasons)

Working is the absolute worst way to generate income, for tax reasons, of course! If you've ever received a W-2, you just might agree.

In general, there are two types of income: earned and unearned. Earned income is what most of us generate by working and receiving wages ie: Form W-2. Unearned income is income generated by more investment-type manners, such as interest, dividends, capital gains, or rents. Earned income tends to be taxed at a much higher rate than income generated through unearned methods.

Then there is the characterization of income (yes, we’re judging income by its character). The character of income is so important that the taxation of it depends on how it was generated. Most income is characterized as "ordinary." Ordinary sounds plain until it’s not. Ordinary income has the potential to be taxed at the highest tax rate of 37% (until it’s time for the Tax Cuts and Jobs Act to revert back to 39.6%). If income is not ordinary, it’s probably a long-term capital gain. Long-term capital gains don’t have the potential to be taxed in the highest bracket.

If you have ever filled out Form 1040 (and I hope you have), you’ll notice Schedules B, C, D, E, and F (if you’re a farmer) are each dedicated to how income is generated and taxed. Schedules B and D tend to lean toward the generation of unearned income, while Schedules C and F tend to lean toward the generation of earned income. Now, Schedule E can be a bit more nuanced since it reports income generated by both earned and unearned methods.

Schedules B, C, D, and E, mostly the latter three, have either expenses, basis, or both that offset income. Why do you think so many “wealthy” people generate “unearned” income through financial securities and real estate? It’s taxed at a lower rate and sometimes not at all. Still want that high-paying dream job?

Note #1: You noticed I didn’t include wages on these Schedules. That’s because wages don’t need a schedule. Wages don’t have any expenses or basis to offset them. Form 1040 (2023) Page 1 Line 1a is all you need for wages. Go check for yourself.

Working sucks more if you’re married and both of you generate similar wage income. You get dinged with a “marriage penalty,” which means you and your spouse would pay more in tax by filing a joint return than if you filed as single taxpayers.

Now for the mathematics as to why working sucks for income tax reasons. Calculations are provided by an off-the-shelf tax software. *Federal tax amounts are rounded up to the nearest hundred.

Let’s say a single person generates $100,000 of income through the various ways listed below; the corresponding federal tax is as follows:

• Wages: $21,950. This is composed of $14,300 of federal tax and $7,650 of payroll tax.
• Dividends: $14,300*
• Interest: $14,300*
• Schedule C or self-employment income: $23,400*

?? (You can learn more about Schedule C in this article I wrote a few years ago: Schedule C vs S-Corp Article)

• Capital Gains Short-term: $14,300*
• Capital Gains Long-term: $6,300*
• Schedule E (ex: rental property): $14,300*

So why do we keep working? Well, it’s relatively easy to obtain skills and a job to generate income. Starting a business or generating significant income from investments requires lots of capital (which many of us don’t have). Almost 64% of the USA is employed (it’s giving a bell curve), and the percentage probably should be higher. All those payroll taxes fund very necessary benefits such as Social Security.

Even with this understanding, it feels that the tax code is unfair to wage earners. The taxability of wage income is significant compared to other methods. Maybe #LLCTwitter (X) has a point, we should all start businesses. Uncle Sam seems to agree, for income tax reasons of course.