The IRS makes a distinction between earned income vs. unearned income. Know the difference.
When you file your taxes, it is important to understand the difference between earned income vs. unearned income. Indeed, one of the tax lessons that we can learn from the wealthy is that unearned income can be beneficial, depending on the current tax laws. Plus, unearned income can be a great way to build up income streams that require you to do a little less work over time.
For the most part, the difference between earned income vs. unearned income is fairly straightforward. Earned income is something that you receive in exchange for the work you do or the services you provide. My income from my home business as a freelance writer is earned income. When you make money in wages, tips, and professional fees, you have earned income.
If you are involved in a business and help with the day-to-day running of the business, you have earned income. You might also need to count foreign income as earned income, and you should talk to a financial or tax professional if you aren't sure if your real estate income counts as earned income or unearned income. But, for most people, the bulk of the income they have is earned.
It's also important to note that, for many people, earned income is taxed at a higher rate. When you talk about your marginal tax bracket, this where earned income is considered. Your investment income might be counted separately, especially if it's made off long-term investments.
When you're talking about effective tax rate vs. marginal tax rate, and the overall percentage of your income that you pay in taxes, there's a reason that there is controversy over what the wealthy pay and what working stiffs end up paying.
Many people equate unearned income with passive income. In some cases, this type of income is passive. Unearned income is money that you receive without doing “work” for it.
According to the IRS, unearned income includes your income from interest, dividends, and capital gains. In some cases, this income is taxed differently. In fact, it might be taxed at a lower rate than your marginal rate. This is why the wealthy try to make money off of assets, rather than offer their labor.
Long-term capital gains are taxed differently than short-term capital gains and regular income. This means that if you are in a higher tax bracket, your long-term gains are often taxed at a lower rate. This can be very helpful to you — especially if you have a lot of investment income.
Other unearned income sources include:
- Income from retirement account distributions
- Unemployment compensation (but you do pay taxes on unemployment benefits)
- Social Security benefits
- Debt forgiveness
- Winnings from gambling
- Some real estate income
It's also worth noting that if you receive income from an estate, trust, partnership or S corporation, without being an active part of the management, that might also be considered unearned income.
Earned vs. Unearned Income — The IRS Expects Its Cut
Realize, though, that even your unearned income has to be reported —and it will likely be taxed. There are places on your tax form to report various types of income.
The IRS wants to know what you make, and where the money comes from. Be sure to account for all of your income, and properly report it. If you under-report, you could face penalties, fines, and even jail. If you need help, consult the IRS web site, or a knowledgeable tax professional.
18 thoughts on “Earned Income vs. Unearned Income”
IRS says alimony is unearned income.
Thank you for that. I should have been clearer, in that the IRS requires you to report alimony as income if you receive it, even though it is considered unearned. http://www.irs.gov/taxtopics/tc452.html
Yes, you should clarify that in the body of the article because it is very confusing.
If I had a loan from my grandmother and I paid against loan for a few years and later she told me it was forgiven – is that considered unearned income?
Is pension income (from a defined benefit plan) earned income or passive income?
From what I can tell, it appears that it’s fully taxable as if it’s earned income. Although there are situations in which you might only have it be partially taxable, as when you contribute after-tax dollars. See here: http://www.irs.gov/taxtopics/tc410.html. However, I am not a tax professional, so I can easily be wrong on this, and cannot offer advice. I suggest you consult with a tax professional when figuring out how to proceed so that you can stand on firmer footing.
Just a heads up you might want to make sure you read and also have someone else read what you write before you post it. I was on the finance page and stated to read it and found a mistake. Here is the sentence (It you under-report, you could face penalties, fines and even jail). The word should be If.
Well, mistakes happen. We all need an editor, and sometimes even the editor misses things. Someday, we’ll all be perfect and never make a single mistake. But until then, a little grace can help us all.
Well I messed up on one of my words I guess my fingers did not want to work..Lol (started)…Oops
Do I have to claim/file unearned income for monies over 10,000 from a one time settlement awarded.
Our son received 20,000 in stock from his great grandparents when he was a baby. We held the stock in a trust fund for him to go towards college. The income from that stock had grown to just over $71,0000. Now 18 years later, he is in college and selling some stock each time he needs to pay for his college tuition and fees, including his housing and meals.
My son is a full time college student and does not work. Is he required to file taxes on the sale of his stock?
You will want to check with a tax professional about this issue. In general, though, the IRS expects all of that to reported. Some of the gains might be offset by other circumstances, but my understanding is that reporting is required. Definitely consult with a knowledgeable tax professional or accountant.
Further more, we file with our son as a dependant on our tax return.
I HAVE A PROBLEM WITH THE VA MEANS TEST ON MY EARNED AND UNEARNED INCOME. ALL I RECIVE IS SSID WITH NO OTHER INCOME TO LIVE ON. ALSO THE STATE OF UTAH- MEDICAID PROGRAM SAYS THAT I MAKE TO MUCH MONEY TO QUALIFY FOR FOOD STAMPS AND OTHER BENIFITS. BUT WITH THE VA THEY FOR SOME REASON THEY USE MY UNEARNED INCOME FROM SSID PAYMENTS AS EARNED INCOME WITCH IS NOT. SO I DON’T QUALIFY FOR 0 DEDUCTABE ON MY MEDICATIONS. THIS DOSNOT MAKE SENCE TO ME. I AM FRUSTRATED WITH THE DOUBLE STANARD THE FEDERAL AND STATE GOVERMENTS HAVE.
Does vacation pay count as earn income, Does Comission count as earn income earn.,
Commission usually does. Vacation pay is usually included in your overall salary. As always, it depends on your situation. Check with a tax professional to see where you stand and what you need to report.
My son won a car at an after the prom party. Everyone that was at the party was entered into the drawing. They did not buy a ticket. Is this considered unearned income and taxed a our rate?
Yes, in many cases this is considered income. Check with a tax professional to be sure, but there have been instances, like in the Oprah case where she gave cars to her audience, where the members were taxed. Winning prizes in game shows have also resulted in taxation.