Table of Contents
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 critical when saving for retirement and paying taxes. Here’s what you need to know about each of them as well as how they affect your finances.
Key Points
• Different types of income will affect your taxes in varying ways.
• Unearned income usually requires more complex tax management than earned income.
• Earned income includes any money generated from a freelance occupation.
• Earned vs. unearned income can also affect your savings for retirement.
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 receive 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 monthly, quarterly, semiannually, or annually.
Interest is usually generated from interest-bearing accounts. These include savings, checking, and money market accounts as well as certificates of deposit (CDs).
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 from which income taxes are withheld, counts as earned income.
Those wages still count as earned income if you’re part of the freelance economy and the companies you work for don’t withhold taxes. They could include wages earned for professional or creative services, driving for a rideshare 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.
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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 the type of unearned income you have, including the following.
Interest
Interest, which is unearned income from financial instruments such as bank accounts and CDs, is taxed the same as earned income.
Dividends
Dividends from investments fall into two categories: qualified and nonqualified. Generally, 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. Nonqualified dividends don’t meet IRS requirements to qualify for the lower tax rate and are taxed at the same rate as ordinary income.
Capital Gains
Investments that are sold at a profit are subject to capital gains taxes. If you held the investment for less than a year, your earnings are subject to short-term capital gains rates, which are equal to your regular 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 taxable income and filing status. The higher your taxable income is, the higher your rate will be.
Social Security
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.
Alimony
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.
Gambling Winnings
Money earned from gambling, including winnings from casinos, lotteries, raffles, and horse races, is fully taxable. This applies to cash and to prizes such as vacations and cars, which are taxed at their fair market value.
Debt Cancellation
If you have a debt canceled or forgiven for less than the amount you were required to pay, the canceled debt is taxable, and you must report it on your tax return. Starting in 2026, this includes the forgiven amount of certain federal student loans. There are exceptions: Public Service Loan Forgiveness, Teacher Loan Forgiveness, and Death and Disability Discharge are still tax-free. Debt payoff planning can help you resolve any outstanding debts you may have.
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 can save.
For example, 401(k) contributions are made with pre-tax dollars, which can then be invested in the account. The investments are allowed to grow tax-deferred until withdrawals are made in retirement, at which point they become subject to income tax. In contrast, your contributions to Roth accounts are made with after-tax dollars. These increase tax-free, and withdrawals made in retirement are not subject to income tax.
Retirement accounts can only be funded with earned income. You can’t 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.
The Takeaway
The difference between earned income and unearned income is an important distinction, 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 its type. Make sure you understand yours and their tax implications. Doing so can significantly impact how you save for your future.
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FAQ
What is the difference between earned and unearned income?
Earned income is cash or in-kind benefits people receive in exchange for work or service, including employment and self-employment. Unearned income is cash or in-kind benefits received without being required to perform work or services.
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.
Do I have to pay taxes on unearned income?
The answer is yes. Though it’s not subject to employment taxes (such as Social Security and Medicare, and, in most cases, payroll taxes), unearned income is generally treated as taxable income.
How does being a freelancer affect my taxes?
According to the IRS, a self-employed individual is generally required to file an annual income tax return and pay estimated taxes quarterly. You have to file an income tax return if your net earnings from self-employment were $400 or more. If your net earnings from self-employment were less than $400, you still have to file an income tax return if you meet any other filing requirement.
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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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