What Is the Difference Between Earned and Unearned Income?

Income comes from different sources, and not all of it is earned through active work. Some income requires effort, like wages from a job, while other types come passively, such as interest or dividends. Understanding the distinction between earned and unearned income helps with tax planning, financial decision-making, and retirement contributions.

The way each type of income is taxed and reported to the IRS varies. Some forms qualify for benefits like Social Security credits and retirement account contributions, while others do not.

Earned Income Basics

Earned income includes wages, salaries, and self-employment earnings—money received in exchange for work. Whether paid hourly, on a salary, or through contract work, this income is subject to payroll taxes, including Social Security and Medicare. The IRS defines earned income as compensation for personal effort.

For employees, earned income is reported on a W-2 form, which details gross earnings, tax withholdings, and pre-tax deductions. Employers withhold federal and state income taxes, as well as FICA taxes (7.65% of wages). Self-employed individuals must calculate and pay their own taxes, including the full 15.3% self-employment tax, covering both the employer and employee portions of Social Security and Medicare.

Earned income also includes business profits for sole proprietors, freelancers, and independent contractors. These individuals report earnings on a Schedule C form and can deduct business expenses such as office supplies, travel, and health insurance premiums if directly related to business operations.

Unearned Income Basics

Unearned income is money received without directly performing work. This includes investment returns, government benefits, and legal settlements. Unlike wages or business earnings, unearned income is not tied to labor or services. While it is generally not subject to payroll taxes, it can still be taxable depending on the source.

Investment income is a major category, with capital gains being a key component. When assets like stocks or real estate are sold for more than their purchase price, the profit is a capital gain. Short-term capital gains (from assets held one year or less) are taxed as ordinary income, while long-term capital gains (from assets held more than a year) are taxed at lower rates, ranging from 0% to 20%, depending on taxable income.

Government benefits such as Social Security payments, unemployment compensation, and veterans’ benefits also fall into this category. Some benefits, like Supplemental Security Income (SSI), are tax-free, while others, such as unemployment payments, are fully taxable. Social Security benefits may be partially taxable if total income exceeds $25,000 for single filers or $32,000 for joint filers, with up to 85% of benefits subject to tax.

Legal settlements and inheritances are additional sources of unearned income. The taxability of lawsuit settlements depends on the reason for the payment—personal injury settlements are generally tax-free, while punitive damages and interest are taxable. Inheritances are not taxed at the federal level for recipients, but estates valued above $13.61 million in 2024 may be subject to federal estate taxes before distribution. Some states also impose inheritance taxes, which beneficiaries must pay based on their relationship to the deceased.

Common Categories

Income is classified based on how it is earned or received. Some forms require active participation, while others generate revenue passively.

Wages and Salaries

Wages and salaries are compensation for work performed. Wages are typically paid hourly, while salaries are fixed amounts paid periodically. Both are subject to federal and state income tax withholding, as well as payroll taxes for Social Security and Medicare.

Employers report these earnings on a W-2 form, which details gross income, tax withholdings, and pre-tax deductions such as 401(k) contributions. Employees may also receive overtime pay, bonuses, or hazard pay, all taxed as ordinary income.

For those earning at or near the federal minimum wage—$7.25 per hour as of 2024—state laws may provide higher minimums. Some states, like California and Washington, mandate wages above $15 per hour. Employers misclassifying workers as independent contractors can face tax penalties and back pay obligations.

Tips and Commissions

Tips and commissions are common in service and sales industries. Tips are voluntary payments given by customers, often in hospitality and personal care professions. Employees must report all cash and credit card tips exceeding $20 per month to their employer, who withholds applicable taxes. Employers also pay a portion of Social Security and Medicare taxes on reported tips.

Commissions are performance-based earnings received by sales professionals, real estate agents, and brokers. These payments may be structured as a percentage of sales revenue or a fixed amount per transaction. Unlike hourly wages, commissions can fluctuate based on market conditions and individual performance.

Both tips and commissions are considered earned income and are subject to income tax. Commission-based workers classified as independent contractors must handle their own tax payments, often making estimated quarterly tax payments to avoid penalties.

Interest, Dividends, Royalties

Unearned income often comes from financial investments. Interest income is generated from savings accounts, certificates of deposit (CDs), and bonds. Banks report interest earnings exceeding $10 annually on Form 1099-INT, and recipients must include this income on their tax returns.

Dividends are payments made by corporations to shareholders. They are classified as either qualified or ordinary dividends, with different tax treatments. Qualified dividends, which meet IRS holding period requirements, are taxed at long-term capital gains rates (0%, 15%, or 20%). Ordinary dividends are taxed as regular income. Companies issue Form 1099-DIV to report dividend payments.

Royalties are payments for the use of intellectual property, such as patents, copyrights, trademarks, or mineral rights. These earnings are typically based on a percentage of revenue from the licensed asset. For example, an author may receive royalties from book sales, or a musician may earn royalties from streaming services. Royalty income is reported on Form 1099-MISC and is subject to income tax. If royalties are part of a business activity, self-employment taxes may also apply.

Rental Proceeds

Income from renting out property, whether residential or commercial, is considered unearned income. Landlords must report rental payments as taxable income but can deduct expenses such as mortgage interest, property taxes, insurance, repairs, and depreciation.

Depreciation allows landlords to deduct a portion of the property’s cost over time. For residential rental properties, the standard depreciation period is 27.5 years, while commercial properties depreciate over 39 years. For example, if a rental home costs $275,000 (excluding land value), the annual depreciation deduction would be $10,000 ($275,000 ÷ 27.5).

Short-term rentals, such as those listed on Airbnb or Vrbo, may be subject to additional tax rules. If a property is rented for fewer than 15 days in a year, the income is not taxable. However, if rented for longer periods, owners must report earnings and may also be required to collect and remit local occupancy taxes.

Differences in Tax Calculation

Earned and unearned income are taxed differently. Earned income is subject to progressive federal tax rates, ranging from 10% to 37% in 2024. Taxpayers with earned income may qualify for deductions like the standard deduction ($14,600 for single filers, $29,200 for married couples filing jointly) or itemized deductions. The Earned Income Tax Credit (EITC) provides tax reductions for lower-income workers, with a maximum credit of $7,430 for taxpayers with three or more qualifying children in 2024.

Unearned income, particularly investment income, is subject to different tax rules. The Net Investment Income Tax (NIIT) adds a 3.8% tax on high earners with modified adjusted gross income (MAGI) above $200,000 for single filers or $250,000 for joint filers. Rental income and partnership distributions may also be subject to passive activity loss (PAL) rules, which limit deductions unless the taxpayer meets material participation thresholds.

Filing Obligations

The IRS requires individuals to report all taxable income. Wages and salaries are reported on Form 1040 using information from a W-2, while self-employed individuals use Schedule C. Those receiving unearned income, such as dividends or rental proceeds, must include amounts from Form 1099-DIV, Form 1099-INT, or Schedule E.

Taxpayers with significant unearned income may need to file additional schedules, such as Schedule D for capital gains or Form 8960 for the NIIT. Estimated tax payments may be required for individuals with substantial unearned income.

Retirement Contribution Eligibility

Earned income determines eligibility for retirement account contributions. Wages, salaries, and self-employment earnings qualify, while unearned income does not. The maximum IRA contribution for 2024 is $7,000, or $8,000 for individuals aged 50 and older. Spousal IRAs allow contributions on behalf of a non-working spouse if the working spouse has sufficient earnings.