What’s the Difference Between Earned and Unearned Income?

Income is how we get compensated for work that we've provided or services we've rendered, but not all income is earned in the same way. There are two distinct varieties of income, earned and unearned.

Each type of income has its own advantages and disadvantages and it's important to know how to distinguish between them for tax purposes and other financial considerations, such as how you can better manage your financial future and set yourself up for stability.

What Is Unearned Income?

Unearned income is money that an individual receives without doing anything to actively earn it. Common types of unearned income sources include:

• Interest payments from bank accounts

• Ordinary dividends from stocks and bonds

• Alimony and child support payments

• Long-term capital gains from investments

• Social Security or disability benefits

• Pensions

• Annuities

• Unemployment benefits

• Gambling Winnings

This type of investment income does not come with any requirements other than the need for a recipient to have funds available in their accounts or investments. You can also receive unearned income from gifts, prizes, and inheritances. Although you don't have to do anything to receive unearned income, it is still taxable. As such, it's important to keep track of all investment-type income and report it on your taxes. You don't want to pay more taxes than you owe, so make sure you're aware of all sources of unearned income and include them when filing.

The Internal Revenue Service (IRS) considers unearned income differently than earned income, so it's important to recognize the distinction between the two. It is also classified as passive income by the IRS.  Passive income affects your income taxes when calculating losses from real estate. Your unearned income, is included in your taxable income and you have to pay taxes on the total amount received, even if it's from multiple sources.

What Is Earned Income?

On the other hand, earned income is money that you receive from working. This could be in the form of wages, salaries, tips, commissions, bonuses, and so on. It's important to note that it doesn't matter how much money you earn — as long as the money was received for the completion of a task or job, then it counts as earned income.

Earned income is the one of the most common sources of income. The most common being earnings such as wages, but it also includes income from a business reported on Schedule C (sole proprietor) or a farm (reported on Schedule F). Earned income can also come from pass through income from Partnerships.

Earned income also comes from work you do as a contractor. Although the payer should issue a form 1099-NEC for the amount they paid you, you must still report this as earned income even if you didn't receive the form.

How They Affect Your Taxes

The IRS taxes different types of income differently.  Additionally different income is used to determine eligibility for certain credits and certain income is subject to additional taxes.

Tax Credits

To calculate the tax benefits of the Earned Income Tax Credit (EITC) on your federal tax return, you only include earned income.  If you have no earned income,  you cannot receive the EITC.  Investment income such as stock dividends don't count for the calculation.  If you have too much adjusted gross income (AGI), you are also ineligible.  Unearned income, like dividend income, is included in AGI, so you could qualify based upon your earned income, but your unearned income could disqualify you.

The tax treatment is the same for the Child Tax Credit, Child and Dependent Care Credit, and Education Credits.

Self-Employment Income

Any earned income from other than a W-2 employer, is subject to additional self-employment taxes.  Self-employed individuals, such as independent contractors, pay a tax equal to 15.3% on their net self-employment income.  This calculation is done on Schedule SE of the federal income tax return.

Even if you don't have a proprietorship filing Schedule C, you can still have income subject to self employment taxes.  Any income reported to you on form 1099-NEC is generally subject to this additional tax burden.

Capital Gains

One of the types of unearned income is capital gains.  This can be long-term or short-term capital gains or capital gain distributions from an investment.  Long term gains are taxed at a potentially lower rate.  The definition of long term is 1 that you've owned the asset longer than one year.

Net Investment Tax

Certain income is subject to an additional Net Investment Tax.  Net Investment Income generally includes many unearned income types.  It includes income types such as interest, dividends, annuities, royalties, and rental income.  Net investment income excludes certain unearned income types such as:

• Unemployment compensation

• Alimony

• Social Security Benefits

• Tax-exempt interest income

When net investment income exceeds certain thresholds of other income, the tax is levied on the excess at 3.8%.

Conclusion

In conclusion, understanding the key differences between earned income and unearned income is crucial for effectively managing your finances and building wealth. By knowing how these two types of income work, you can make informed decisions about investments, tax implications, and overall financial strategy. So, whether you're earning an income through hard work or through smart investments, remember that knowledge is power when it comes to your financial future.