Earned Income vs. Investment Income: Key Differences

All income is not created equal, especially when it comes to taxes. The source of your money, whether from a paycheck or from your assets, determines how it is classified by the Internal Revenue Service (IRS). This classification directly influences your tax liability and eligibility for certain financial benefits. The distinction impacts everything from the tax rates you pay to your ability to save for retirement.

Defining Earned Income

Earned income is compensation derived from active participation in a job or business venture. It represents the money you make by trading your time and effort, either as an employee or as your own boss. This category includes wages, salaries, tips, commissions, and bonuses. For employees, this income is reported annually on a Form W-2, which details the total earnings and taxes withheld by an employer.

Self-employed individuals also generate earned income, though the calculation and reporting differ. Their income is considered the net earnings from their business operations. This figure is determined by subtracting business expenses from gross business income, a calculation performed on Schedule C (Form 1040), Profit or Loss from Business.

Beyond typical employment, certain other payments can qualify as earned income. These may include union strike benefits and some long-term disability benefits received prior to minimum retirement age.

Defining Investment Income

Investment income is the return generated from your capital and assets, rather than from your direct labor. It is money your money makes, often with minimal daily effort required on your part. The most common sources of investment income include interest and dividends. Interest can be earned from savings accounts, money market accounts, certificates of deposit (CDs), and bonds.

Dividends are distributions of a company’s profits to its shareholders. These can be classified as either “qualified” or “non-qualified,” a distinction that has tax implications.

Capital gains are another primary type of investment income. A capital gain occurs when you sell an asset—such as stocks, bonds, or real estate—for more than your original purchase price, known as your basis. The tax treatment of these gains depends on how long you held the asset. Gains from assets held for one year or less are considered short-term, while gains from assets held for more than a year are long-term.

Rental income from real estate properties and royalties from intellectual property, like books or patents, also fall under the umbrella of investment income. This income is reported on Schedule E (Form 1040), Supplemental Income and Loss. While managing a rental property involves effort, the income is generated by the asset itself, classifying it as investment-related for tax purposes.

Key Tax Differences

While both are subject to federal income tax, the rates and additional taxes that apply can vary. Certain types of investment income, specifically long-term capital gains and qualified dividends, benefit from preferential tax rates. These rates are 0%, 15%, or 20%, depending on your overall taxable income, and are often lower than the ordinary income tax rates applied to earned income, which range from 10% to 37%.

Another difference is the application of payroll taxes. Earned income is subject to Federal Insurance Contributions Act (FICA) taxes, which fund Social Security and Medicare. For employees, this tax is 7.65% of their earnings, with their employer paying a matching amount. Self-employed individuals pay the full 15.3% through the Self-Employment Contributions Act (SECA) tax on their net earnings. Investment income is exempt from FICA and SECA taxes.

Higher-income taxpayers may face an additional tax on their investment income. The Net Investment Income Tax (NIIT) is a 3.8% tax that applies to the lesser of your net investment income or the amount your modified adjusted gross income (MAGI) exceeds certain thresholds. These thresholds are $200,000 for single filers and $250,000 for those married filing jointly. This tax applies only to investment income, not earned income.

Impact on Tax Credits and Retirement Contributions

Many tax strategies and government benefits are contingent upon having sufficient earned income. One impact is on retirement savings. To contribute to a traditional or Roth Individual Retirement Arrangement (IRA), you must have earned income. Your annual contribution limit cannot exceed your total earned income for the year, up to the statutory maximum.

Eligibility for certain tax credits is also tied directly to earned income. The Earned Income Tax Credit (EITC), for example, is a refundable credit for low- to moderate-income working families. The amount of the credit is calculated as a percentage of earned income up to a certain level. Having too much investment income can disqualify you from claiming the EITC. For the 2025 tax year, a taxpayer with more than $11,950 in investment income is ineligible for the credit.