Earned vs. Unearned Income: What's the Difference?

Earned income is the money you earn through work or services, while unearned income is the money you receive without actively working for it. Both are crucial for financial planning and diversification.

Do you know that the Internal Revenue Service (IRS) classifies different types of income, including earned and unearned income, for tax purposes? Understanding the distinction between these types of income can help individuals accurately report their income and avoid any potential tax issues.

Earned income is money you make from working, such as salaries, wages, tips and professional fees. In contrast, unearned income is the money you receive without working. This includes dividends, interest and rental income. Learn the distinction between earned and unearned income to maximize your financial resources.

Defining Earned Income vs. Unearned Income

What Is Earned Income?

Earned income refers to the money that an individual receives in exchange for their work or services provided. This can include wages, salaries, bonuses, and tips earned through employment. It is the most common form of income for many people and is typically reported on a W-2 form for tax purposes.

Types of Earned Income

• Salaries include periodic payments from an employer specified in an employment contract. Unlike other specific wages or freelance work, a salary is a periodic payment for work.
• Wages include freelance work or a job paid by the hour or other unit rather than periodically.
• Tips include bonuses paid for certain professions like waiters, servers and others in service-oriented industries. 
• Commissions include variable-pay remuneration based on services and sales. Salespeople often receive commissions
• An honorarium is a payment for professional services. Usually, the services are rendered nominally without charge.
• Self-employment income is any income earned by people who work as freelancers, independent contractors, sole proprietors or business owners.

What Is Unearned Income?

Unearned income refers to any money received from investments, such as dividends, interest, rental income, or royalties, without actively working for it. This type of income is not directly tied to any services provided by the individual, but rather comes from assets owned. Unearned income is considered passive income and can be a source of financial stability for individuals who have investments generating consistent returns. It is important to report unearned income for tax purposes, and it can play a significant role in personal financial planning.

Types of Unearned Income

• Alimony or spousal support is a legal obligation of one person to provide financial support before or after marital separation or divorce.
• Inheritance is assets or funds received by the beneficiary after a death. 
• Rental income is earned from renting real estate properties. 
• Dividends are a distribution of profits by a corporation to its shareholders, generally considered passive income. 
• Royalties are payments made for the use of an asset. For example, you could receive royalties for the use of music, a movie, a book, an audiobook or other intellectual property. Royalties are paid to the asset owner by anyone using the asset. 
• Interest is paid on investments, including certificates of deposit (CDs), loans, and checking or savings accounts.

What Is the Difference Between Earned and Unearned Income?

Whether you're navigating your income sources for budgeting purposes or tax optimization, recognizing the differences between earned and unearned income is essential. 

Income source:

Earned income is a source of income that is generated through active work or services provided by an individual. This can include wages, salaries, bonuses, commissions, and tips received from employment.

Unearned income is a source of income that is not directly earned through working or providing goods or services. This type of income includes interest, dividends, rental income, royalties, and capital gains.

Active vs. Passive Participation:

Earned income requires your active participation. This includes a job with a set salary or hourly wage.

Unearned income is passive in nature. It is typically earned without direct labor or participation; it is generated by owning or investing in assets. You'll earn it whether you're actively engaged in specific activities or not.

Tax Implications:

Earned income is usually subject to federal income tax, Social Security and Medicare taxes as well as any applicable state and local income taxes. 

Unearned income is subject to different tax rules than earned income. It may be subject to federal income tax, but tax rates vary based on the type of income. You may benefit from positive tax treatment on some types of unearned income, such as capital gains. Certain unearned income may even be tax-exempt.

Retirement Savings:

You can only contribute earned income to retirement accounts such as 401(k)s and individual retirement accounts (IRAs).

On the other hand, unearned income is generally not used for contributions to traditional retirement accounts but can be used for contributions to Roth IRAs (subject to income limits), which are funded with after-tax dollars. unearned income in the form of interest and dividends can be a powerful compounding tool to build retirement savings over time. Building multiple income streams can create long-term financial stability. 

Earned Income vs. Unearned Income: Benefits Explained

Earned income and unearned income both have benefits. While earned income is directly connected to business activities or effort, you'll get unearned income regardless of business actions. Both can create financial stability. 

• Most families rely on earned income as their primary source of income. Earned income creates immediate cash flow that contributes toward Social Security and Medicare. Earned income may come with benefits like health insurance or employer retirement contributions. Earned income also has a distinct advantage for retirement planning.
• While earned income is often seen as stable and predictable, creating a solid financial foundation, you can build passive or unearned income sources for long-term wealth. Most notably, unearned income can help you grow wealth through investments or earn money while you sleep. Unearned income or investment interest is a powerful tool for building long-term wealth. It also comes with potential tax benefits.

Ideally, it's not a question of unearned income versus earned income. Having both earned and unearned income can diversify income sources and support long-term wealth-building. 

Final Tips on Earned vs. Unearned Income

Earned and unearned income both offer excellent opportunities for long-term financial security. Creating multiple income streams that include earned and unearned income can offer the greatest stability and financial freedom.

Frequently Asked Questions