Does Passive Income Affect Social Security?
Understand how your income types interact with Social Security benefits. Get clear insights on earnings and their potential impact on your retirement.
Understanding how different income sources impact Social Security benefits is a common concern for many individuals. Social Security provides a foundational component of retirement income, replacing a portion of pre-retirement earnings. This article clarifies whether income classified as “passive” affects Social Security benefits and distinguishes it from other income types that may lead to benefit adjustments.
Understanding Passive and Earned Income
A fundamental distinction exists between passive income and earned income when considering Social Security. Earned income represents compensation received for services performed, typically through active participation in a trade or business. This category includes wages, salaries, and net earnings from self-employment. This type of income is generally subject to Social Security and Medicare taxes, also known as FICA taxes or self-employment taxes.
In contrast, passive income is typically derived from investments or businesses in which an individual does not actively participate. Common examples include interest earned from savings accounts or bonds, dividends from stocks, and capital gains from the sale of assets like real estate or securities. Rental income from properties where the owner is not considered a real estate professional or does not materially participate in the rental activity also falls under passive income. This income is generally not subject to self-employment taxes.
How Social Security Benefits Are Affected by Earnings
Social Security benefits can be affected by income, but only under specific circumstances tied to earned income. The primary mechanism for this impact is the Retirement Earnings Test (RET), which applies only to individuals receiving Social Security benefits before reaching their full retirement age (FRA) while still working. Full retirement age (FRA) varies based on birth year, typically between 66 and 67.
For beneficiaries who are under their full retirement age for the entire year, a portion of their benefits may be withheld if their earned income exceeds a certain limit. In 2025, this annual earnings limit is $23,400. For every $2 earned over this limit, $1 in Social Security benefits will be withheld.
A different, more generous earnings limit applies in the year a beneficiary reaches their full retirement age, but only for the months before reaching that age. In 2025, this higher limit is $62,160. For earnings above this threshold, $1 in benefits is withheld for every $3 earned. Once a beneficiary reaches their full retirement age, the Retirement Earnings Test no longer applies, and they can earn any amount of income without their Social Security benefits being reduced. Benefits withheld due to the earnings test are not permanently lost; they are typically repaid in the form of higher monthly benefits once the individual reaches full retirement age.
Common Passive Income Sources and Social Security
Common types of passive income do not affect Social Security benefits. This is because these income streams are not considered “earned income” by the Social Security Administration and are not subject to the Retirement Earnings Test.
Examples include investment income such as dividends received from stock holdings, interest accrued from savings accounts or bonds, and earnings from mutual funds. Capital gains realized from the sale of various assets, including stocks or real estate, also fall into this category. Rental income from properties where the recipient is not materially participating in the business, along with pension payments, annuities, and distributions from retirement accounts like 401(k)s or IRAs, are classified as passive or unearned income. While these passive income sources do not directly reduce Social Security benefits, they can contribute to an individual’s overall taxable income, which may lead to a portion of Social Security benefits becoming taxable.
Distinguishing Income in Business Structures
The classification of income can become more intricate within various business structures, particularly for self-employed individuals and business owners. Income from a trade or business in which an individual actively participates is considered earned income. Net earnings from self-employment are subject to self-employment taxes, which include contributions to Social Security and Medicare. The Internal Revenue Service (IRS) uses “material participation” tests to determine if a taxpayer’s involvement in a business or rental activity is considered active.
For owners of S corporations, the distinction is particularly relevant. An S corporation owner who provides services to the business must pay themselves a “reasonable salary,” which is reported as W-2 wages. This salary constitutes earned income and contributes to their Social Security earnings record. However, any distributions taken from the S corporation’s profits beyond this reasonable salary are not considered earned income and are not subject to Social Security or Medicare taxes.
Misclassification of income, especially by taking excessive distributions in lieu of a reasonable salary, could lead to scrutiny from the IRS. The IRS has the authority to reclassify distributions as wages if the salary paid is deemed unreasonable for the services rendered. Such reclassification could result in unexpected tax liabilities, including self-employment taxes, and potentially impact Social Security benefits calculations by altering an individual’s earnings record. Proper classification based on actual involvement and IRS guidelines helps avoid issues with Social Security benefits.