There are two basic types of income: earned and unearned. Earned income is the money you make from working, and unearned income is money you receive that isn’t tied to a business or job.
The difference between these two types of income is very important when it comes to saving for retirement and paying your taxes. Here’s what you need to know about each of them, and how they affect your finances.
What Is Unearned Income?
Unearned income is a type of passive income. It’s money you make without working or performing some kind of professional service. For example, money you get from investing, such as dividends, interest, and capital gains is unearned income.
Other types of unearned income include:
• Retirement account distributions from a 401(k), pension, or annuity
• Money you received in unemployment benefits
• Taxable social security benefits
• Money received from the cancellation of debt (such as student loans that are forgiven)
• Distributions of any unearned income from a trust
• Alimony payments
• Gambling and lottery winnings
Dividends from investments in the stock market and interest are two of the most common forms of unearned income. Dividends are paid when a company shares a portion of its profits with stockholders. They may be paid on a monthly, quarterly, semi-annual or annual basis.
Interest is usually generated from interest bearing accounts, including savings accounts, checking accounts, money market accounts, and certificates of deposit (CDs).
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How is Earned Income Different From Unearned Income?
Earned income is the money you make from a job. Any money you earn from an employer — including wages, fees, and tips in which income taxes are withheld — counts as earned income.
If you’re part of the freelance economy and the companies you work for don’t withhold taxes, those wages still count as earned income. These could be wages earned by performing professional or creative services, driving a car for a ride share service, or running errands.
Money you make from self-employment — if you own your own business, for example — also counts as earned income, as does money you earn from a side hustle.
Other types of earned income include benefits from a union strike, disability benefits you receive before you reach full retirement age, and nontaxable combat pay.
This guide can help you learn about all the different types of income there are.
How Income Types Affect Taxes
All earned income is taxed at your usual income tax rate.
Taxes on unearned income are more complicated and depend on what type of unearned income you have, including:
Interest, which is unearned income from things like bank accounts and CDs, is taxed the same as earned income that you work for.
Dividends from investments fall into two categories: qualified and non-qualified. Generally speaking, qualified dividends are those paid to you by a company in the U.S. or a qualified foreign company, and are taxed at a lower rate. Non-qualified dividends don’t meet IRS requirements to qualify for the lower tax rate and are taxed at the same rate as ordinary income.
Investments that are sold at a profit are subject to capital gains taxes. If you held the investment for less than a year, your profits are subject to short-term capital gains rates, which are equal to your normal income tax rate. If you kept the investment for a year or more, it’s subject to long-term capital gains rates, which means it will be taxed at 0%, 15% or 20%, depending on your income. The higher your income, the higher your rate.
If your income is more than $25,000 a year for individuals or $32,000 a year for married couples filing jointly, you will pay federal income tax on a portion of your Social Security benefits. You’ll be taxed on up to 50% of your benefits if your income is between $25,000 and $34,000 for an individual, or $32,000 to $44,000 for a married couple. And you’ll be taxed on up to 85% of your benefit if your income is more than that.
As a result of the Tax Cuts and Jobs Act of 2017, alimony payments that are part of divorce agreements made after January 1, 2019 are not taxable by the person who is paying the alimony, nor are they taxable for the person receiving the alimony.
Money you earn from gambling — including winnings from casinos, lotteries, raffles, and horse races — are all fully taxable. This applies not only to cash, but also to prizes like vacations and cars, which are taxed at their fair market value.
If you have a debt that is canceled or forgiven for less than the amount you were supposed to pay, then the amount of the canceled debt is subject to tax and you must report it on your tax return.
If you have debts to pay off, debt payoff planning can help you pay what you owe.
How Earned vs Unearned Income Affects Retirement Savings
Retirement accounts, including 401(k)s, IRAs, and the Roth versions of both, provide tax advantages that help boost the amount that you are able to save.
For example, 401(k) contributions are made with pre-tax dollars, which can then be invested in the account. The investments are then allowed to grow tax deferred until withdrawals are made in retirement, and then they are subject to income tax. Contributions to Roth accounts are made with after-tax dollars. These grow tax free, and withdrawals made in retirement are not subject to income tax.
You must fund your retirement accounts with earned income. You cannot use unearned sources of income to make contributions.
There are certain exceptions to this rule. If you’re married and you file a joint return with your spouse and you don’t have taxable compensation, you may be able to contribute to an IRA as long as your spouse did have taxable compensation.
Recommended: 3 Easy Steps to Starting a Retirement Fund
The difference between earned income and unearned income is an important distinction to comprehend, especially when it comes to paying your taxes. Unearned income, which is income you make not from a job but through other means, such as investments, can be taxed at different rates, depending on what type of unearned income it is. Make sure you understand yours — and the tax implications. Doing so can have a big impact on how you save for your future.
Keep tabs on all the types of income you have by tracking your checking, savings, investment, and retirement accounts in one place with the SoFi Insights money tracker app. It allows you to organize your accounts on a single dashboard, as well as monitor your credit score and budget for financial goals.
Why do I need to know the difference between earned and unearned income?
It’s important to understand the difference between earned and unearned income because the two may be taxed differently. Also, in most cases, you must use earned income to fund your retirement accounts.
What is an example of unearned income?
Unearned income is money you receive without working for it. Interest, such as that from a bank account, and dividend payments are two of the most common types of unearned income.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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