Determining Income Type, Differences With Earned & Unearned Income (2024)

When it comes to filing taxes, the distinction between earned and unearned income might seem like a minor one. However, the IRS doesn’t think so, and if you mix up earned and unearned income on your tax returns or forget income sources of either type, you could end up with a lot of tax problems on your hands.

Defining Earned Income and Unearned Income

Every taxpayer should know the difference between earned and unearned income. The distinction isn’t too complicated, but it’s very important for your taxes.

  • Earned income is the money you make in exchange for the work you do. For most people, almost all the money they make is earned income. Any money earned in professional wages or fees — including tips — counts as earned income. Reimbursem*nts from your employer for travel expenses, including meals, accommodations, and transportation, also count as earned income. True alimony is considered earned income as well, as is most foreign income or money earned through real estate holdings (although you might want to speak with an experienced tax representative if you aren’t sure about whether different money streams count as earned income).
  • Unearned income involves the money you make without having performed a professional service. Unearned income includes money-making sources that involve interest, dividends, and capital gains. Additional forms of unearned income include retirement account distributions, annuities, unemployment compensation, Social Security benefits, and gambling winnings. Other forms of income, such as money from an estate, trust, or partnership, may also be considered unearned income.

You don’t necessarily have to memorize every type of income and which category it falls into. Just remember: if you sold goods or provided labor, the money you made is earned income. If you have investment income or other sources of income that don’t involve any work or services, that money is unearned income.

How Income Types Affect Your Taxes

United States residents pay two primary taxes on earned income: payroll taxes (including Social Security and Medicare taxes) and federal and state income taxes. Social Security and Medicare taxes fund the two federal programs whose names they bear.

The federal government deducts payroll taxes from your paycheck, and the earnings cap is set at $137,700 for 2020 (which means you won’t owe any additional Social Security taxes after you exceed this cap). An amount equal to 12.4% of your earned income goes toward Social Security, but your employer splits this tax with you 50-50, so you only pay 6.2% in practice. (Self-employed people must pay the full 12.4%, but half the amount is tax-deductible in most instances.)

Medicare works somewhat like Social Security taxes: you and your employer split the tax bill, and each owes taxes equal to 1.45% of your income, for a total of 2.9%. However, unlike with Social Security taxes, there is no earnings cap on Medicare taxes. You must also pay the full 2.9% on any self-employment income, and you can’t take tax deductions to offset that amount.

Unearned income works differently than earned income. You don’t have to pay any payroll taxes, including Social Security and Medicare, on the various forms of unearned income. However, your unearned income (line 37 of yourForm 1040) will count toward your adjusted gross income on your state and federal tax returns.

Usually, you’ll pay taxes on unearned income at your personal marginal tax rate; however, in certain cases (for example, capital gains and qualified dividends), your unearned income will be taxed at a lower rate. Some unearned income gets taxed at a much lower rate. For example, tax on long-term capital gains is zero if you earn less than $39,376 and only 15 percent if you earn between $39,376 and $434,550.

RELATED: What Is The Difference Between Standard and Itemized Deductions?

Income Type Can Have Major Implications on Retirement Savings

If you start saving early for retirement, you’ll end up accruing quality sources of unearned income, which is exempt from payroll taxes. Pre-tax salary deferral contributions to your retirement account or pension can lower your income tax liabilities, so these contributions will come in very handy once you retire and begin relying more on unearned income. In some cases, you may want to diversify your unearned income sources among options like Roth IRAs and traditional 401(k)s so you can combine the various tax benefits.

Also, if you’ve retired from working for others and are now self-employed, make sure to keep track of your personal payroll taxes to avoid any surprises come tax season.

Need Help With Unearned Income or Other Tax Issues? Contact S.H. Block Tax Services Today

The more unearned income you have in your portfolio, the more complicated your taxes can get. If you’re struggling to track your various sources of unearned income, contact S.H. Block Tax Services. We can help you avoid errors that could lead to substantial taxes and fees or even an audit.

You can reach the team at S.H. Block and schedule your free consultation by calling (410) 872-8376 or using the quick contact form on this page. Together, we can work with you to diagnose any tax issues and create a plan to resolve these problems once and for all.

The content provided here is for informational purposes only and should not be construed as legal advice on any subject. Please read our full disclaimer here.

Determining Income Type, Differences With Earned & Unearned Income (2024)


Determining Income Type, Differences With Earned & Unearned Income? ›

Earned income refers to the money that you make from working, including salaries, wages, tips and professional fees. Unearned income, comparatively, is the money that you receive without performing work, such as dividends, interest or rental income.

How is earned income different from unearned income? ›

Be sure students understand key vocabulary: ° Earned income: Money made from working for someone who pays you or from running a business or farm. This includes all the income, wages, and tips you get from working. ° Unearned income: Income people receive even if they don't work for pay.

What types of income are considered earned income? ›

For the year you are filing, earned income includes all income from employment, but only if it is includable in gross income. Examples of earned income are: wages; salaries; tips; and other taxable employee compensation. Earned income also includes net earnings from self-employment.

Are income taxes are paid on both earned and unearned income? ›

Income tax: Federal, state, and local taxes on income, both earned (salaries, wages, tips, commissions) and unearned (interest, dividends). Includes both personal and business or corporate income taxes.

Does gross income include earned and unearned income? ›

Earned income includes salaries, wages, tips, professional fees, and taxable scholarship and fellowship grants. Gross income is the total of your unearned and earned income.

What types of income are not considered earned income? ›

Earned income is any income received from a job or self-employment. Earned income may include wages, salary, tips, bonuses, and commissions. Income derived from investments and government benefit programs would not be considered earned income.

What is an advantage of having unearned instead of earned income? ›

Unearned income offers various potential benefits. It allows individuals to earn money without actively working, providing an additional income source and can increase their financial security. Moreover, unearned income could offer tax advantages, as some forms of it are taxed at lower rates than earned income.

What is an example of unearned income? ›

Unearned income is not acquired through work or business activities. Examples of unearned income include inheritance money and interest or dividends earned from investments. Tax rates on unearned income are different from rates on earned income.

How to calculate earned income? ›

Earned income is your total earnings after deducting taxes you've already paid, applying credits such as the EIC and other deductions. Earned income that might not be common can include union strike benefits, specific retirement pensions and long-term disability benefits.

What is not counted as income? ›

Nontaxable income won't be taxed, whether or not you enter it on your tax return. The following items are deemed nontaxable by the IRS: Inheritances, gifts and bequests. Cash rebates on items you purchase from a retailer, manufacturer or dealer.

Why is it important to distinguish between earned income and unearned income? ›

Unearned income works differently than earned income. You don't have to pay any payroll taxes, including Social Security and Medicare, on the various forms of unearned income. However, your unearned income (line 37 of your Form 1040) will count toward your adjusted gross income on your state and federal tax returns.

Does unearned income affect Social Security benefits? ›

Unearned income we do not count. (a) General. While we must know the source and amount of all of your unearned income for SSI, we do not count all of it to determine your eligibility and benefit amount. We first exclude income as authorized by other Federal laws (see paragraph (b) of this section).

How much money can a 70 year old make without paying taxes? ›

If you are at least 65, unmarried, and receive $15,700 or more in nonexempt income in addition to your Social Security benefits, you typically need to file a federal income tax return (tax year 2023).

What classification is unearned income? ›

Unearned revenue is an account in financial accounting. It's considered a liability, or an amount a business owes. It's categorized as a current liability on a business's balance sheet, a common financial statement in accounting.

What age do you stop filing taxes? ›

Taxes aren't determined by age, so you will never age out of paying taxes. Basically, if you're 65 or older, you have to file a return for tax year 2023 (which is due in 2024) if your gross income is $15,700 or higher. If you're married filing jointly and both 65 or older, that amount is $30,700.

Does Social Security count as earned income? ›

Unearned Income is all income that is not earned such as Social Security benefits, pensions, State disability payments, unemployment benefits, interest income, dividends, and cash from friends and relatives. In-Kind Income is food, shelter, or both that you get for free or for less than its fair market value.

What is the difference between earned income and unearned income brainly? ›

Final answer:

Earned income is made through work and labor, whereas unearned income comes from investments, rental property, and inheritance (option c).

What distinguishes earned income from unearned income and provide an example of each quizlet? ›

Earned is income you receive from working for pay such as wages or salaries. Unearned is income received from other sources such as interest from savings accounts.

What is the meaning of earned income? ›

Earned Income means monetary compensation received from services rendered including wages, salaries, bonuses, commissions, tips, etc.

What is the difference between earned income and passive income? ›

Key Points. Earned income is the money you make in salary, wages, commissions, or tips. Investment income is money you make by selling something for more than you paid for it. Passive income is money you make from something you own, without selling it.

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