What Is Not Considered Earned Income?
Clarify the specific types of income that do not fall under the definition of earned income. Essential for financial planning and tax accuracy.
Earned income generally refers to money received from active participation in a job or business. This includes wages, salaries, tips, commissions, and net earnings from self-employment. This article clarifies types of income that are not considered earned income.
Income from Investments
Income derived from investments is not classified as earned income because it represents a return on capital rather than compensation for services performed. Interest income, such as that earned from savings accounts, certificates of deposit (CDs), or bonds, falls into this category. The Internal Revenue Service (IRS) considers interest as unearned income, signifying that the money itself is working to generate the income.
Similarly, dividend income, paid to shareholders by corporations, is not considered earned income. These payments are distributions of company profits to investors. Profits realized from the sale of assets, known as capital gains, also do not qualify as earned income, including gains from selling stocks, real estate, or other investments.
Retirement and Social Security Payments
Payments received from retirement plans and Social Security are not considered earned income. Pensions, including those from defined benefit plans or government pensions, represent distributions from past contributions or deferred compensation for prior work. Annuity payments, which are streams of income from contracts often purchased from insurance companies, also fall under this classification.
Social Security benefits, such as retirement, survivor, or disability payments, are also categorized as unearned income. These benefits are a result of contributions made over a working lifetime to a government program. These types of income are generally viewed as distributions from accumulated funds or government programs rather than current earnings from active employment.
Certain Government and Support Payments
Government benefits and support payments are not considered earned income. Unemployment compensation, provided by states to individuals who have lost their jobs, is one example. While taxable, these benefits are for temporary assistance and not for services rendered.
Welfare benefits, including programs like Temporary Assistance for Needy Families (TANF), are also unearned income. Child support payments are another form of unearned income, as they are financial contributions for a child’s care and are generally not taxable to the recipient. Alimony, or spousal support, is also classified as unearned income for the recipient. These payments serve a supportive function rather than compensating for work or services.
Passive Income and Other Unearned Sources
Income generated without active material participation is deemed unearned. Rental income from properties is considered passive or unearned income if the owner does not materially participate in the rental activity. This means it is not subject to self-employment taxes like Social Security and Medicare. However, if rental activity rises to the level of a business with active management, it may be treated differently for tax purposes.
Royalty income, paid for the use of intellectual property or natural resources, is unearned income when the recipient is not actively involved in the creation or ongoing management of the source. Gambling winnings, from lotteries, casinos, or other games of chance, are taxable but not earned income.
Gifts and inheritances are transfers of wealth and not classified as earned income. Life insurance proceeds received upon the death of the insured are also excluded from earned income. These diverse sources represent returns that do not stem from a direct exchange of labor or services.