Understanding the difference between what is unearned income and what is earned income is important, because they receive different tax treatments. The difference matters for other tax considerations, too, such as IRA contributions and the Earned Income Tax Credit.
Let's review earned income first. Per the IRS, it includes what you would expect: "wages, salaries, tips, and other taxable employee pay." It also includes many kinds of self-employment income, including income from owning a farm, working as clergy for any religion, or as a statutory employee.
A statutory employee is technically an independent contractor, but has work conditions that permit him or her to be treated as an employee for certain tax purposes. Examples include life insurance agents, certain delivery people, and traveling salespeople.
Union strike benefits also qualify, as do long-term disability benefits that you receive before you reach the minimum retirement age. Past the minimum retirement age, the IRS considers the disability income unearned.
Gambling winnings are considered unearned income. Photo: Geoffrey Fairchild, Flickr.
Unearned income is a less obvious concept. If earned income is mainly the result you engaging in an activity in order to earn money, then unearned income generally comes to you without your having performed services for it. Here are some examples of unearned income according to the IRS:
- Interest income
- Dividend income
- Capital gains and capital gain distributions
- Retirement income (e.g. from pensions, annuities, and IRA or 401k withdrawals)
- Social Security benefits (only a portion is taxable)
- Unemployment benefits
- Child support
- Some distributions from trusts
- Gambling winnings
- Forgiven debts
Income received for work performed as an inmate in a prison might seem to qualify as earned, but it's actually classified as unearned.
Tax rules are different for unearned income. Most investment income gets taxed at a rate that's lower than most folks' ordinary income tax rate. Those with very low incomes will pay 0% on qualified dividends and long-term capital gains, while most people will pay 15%. High earners will pay 20%. Short-term capital gains are taxed at ordinary income tax rates, though, providing an incentive to hang on to appreciated assets for at least a year and a day.
Some unearned income is not taxed at all, as is generally the case with life insurance proceeds when the insured person dies.
It's important to note that IRA contributions can only be made with earned income. If you have an IRA, but over the course of a year you don't collect any earned income and instead subsist on unemployment benefits and gambling winnings, you will not be able to make a contribution to your IRA for that year. Similarly, while kids can have IRAs, they can't fund them with birthday and allowance money. If they earn money babysitting or dog walking, though, that's earned income, and can qualify them for IRA contributions. Interestingly, alimony counts as earned income for the sole purpose of IRA contributions even though it is considered unearned income for your taxes.
The bottom line is that it's important to understand what kind of income you receive over the course of a tax year, because different kinds of income will get different tax treatments. Be prepared to deal with a variety of tax rates.