Earned Income vs. Unearned Income

The IRS makes a distinction between earned income and unearned income. Know the difference.

When you file your taxes, it is important to understand the difference between earned income and unearned income. Indeed, one of the tax lessons that we can learn from Mitt Romney 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.

Earned Income

For the most part, the difference between earned income and 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. And, interestingly, true alimony is considered earned income (but child support isn’t). 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.

Unearned Income

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. Right now (this is due to expire soon), dividends are taxed as long-term capital gains, which means this income might be taxed at a lower rate than your marginal tax rate.

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.

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.

Written by Miranda Marquit

Miranda Marquit is a freelance writer and professional blogger, specializing in personal finance, small business, and investing topics. She writes for a number of financial web sites and blogs, and has been featured in numerous media. Read about life as a freelancer at MirandaMarquit.com and in her book Confessions of a Professional Blogger.

13 Responses to Earned Income vs. Unearned Income

  1. 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?

    • 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.

  2. 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.

  3. 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.

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