Earned income refers to the money that you make from working, including salaries, wages, tips and professional fees. Unearned income, comparatively, is the money that you receive without performing work, such as dividends, interest or rental income. Understanding the differences between both can help you develop retirement planning and investing strategies, as well as minimize your tax liabilities.
A financial advisor can help you optimize your investment portfolio to lower your tax liability.
What Is Unearned Income?
Unearned income is not earned through active employment or business activities. It is typically passive in nature and generated from different types of financial investments, assets and other sources.
Unearned income can influence your finances in several ways. These include:
- Taxation: Unearned income is typically subject to different tax rules and rates than earned income. Therefore, understanding how unearned income is taxed can have a significant impact on your overall tax liability and financial planning.
- Financial planning: Unearned income can be a valuable source of passive income, such as interest, dividends, or capital gains, which can play a crucial role in your financial planning, including retirement planning and investment strategies.
- Income diversity: Unearned income provides a level of income diversification, which reduces your reliance on a single source of income, and can enhance your financial stability.
- Retirement income: Many forms of unearned income, such as Social Security benefits, pensions and investment income are commonly used to provide income during retirement.
- Estate planning: Unearned income, such as inheritance or royalties, can have implications for estate planning, impacting how assets are passed on to heirs and beneficiaries.
- Government assistance: For individuals with low income, unearned income sources like Social Security benefits and government assistance programs can be essential for meeting basic living expenses. Knowledge of eligibility and application processes is vital.
- Investment decisions: Unearned income is often derived from investments, and understanding how to manage and optimize these investments is important for building and preserving wealth.
Differences Between Earned and Unearned Income
Knowing the differences between earned and unearned income is a fundamental aspect of your financial literacy and effective financial planning. Take note of these five key differences as you optimize your financial strategies, make investment decisions, manage tax liability and plan for both short- and long-term financial goals:
Source of Income:
- Earned income: Earned income is derived from active participation in work or business activities. It includes wages, salaries, self-employment income, and profits generated through active labor.
- Unearned income: Unearned income, on the other hand, is income generated from passive sources, such as investments, assets, or other sources that do not require active participation or labor.
Active vs. Passive:
- Earned income: Earned income necessitates active effort and labor. It is the result of trading time, skills, or services for compensation.
- Unearned income: Unearned income is passive in nature. It is typically earned without direct labor or participation; it is generated by owning or investing in assets.
Taxation:
- Earned income: Earned income is generally subject to federal income tax, Social Security, and Medicare taxes (FICA), and possibly state and local income taxes.
- Unearned income: Unearned income may be subject to federal income tax, but the rates and rules can vary based on the type of income. Some forms of unearned income, like capital gains, may benefit from preferential tax rates, and certain unearned income may be tax-exempt.
Retirement Account Contributions:
- Earned income: Earned income is often used to make contributions to retirement accounts such as 401(k)s and Traditional IRAs.
- Unearned income: Unearned income is generally not used for contributions to traditional retirement accounts but can be used for contributions to Roth IRAs (subject to income limits), which are funded with after-tax dollars.
Types of Unearned Income
There are various types of unearned income, from dividends to inheritance. Here are some of the most common:
- Interest: You may earn interest on a number of different types of investments including certificates of deposit (CDs), loans, checking or savings accounts and more. Some types of interest are taxed differently, though, such as interest earned on municipal bonds.
- Alimony: If you’re divorced and receiving money from a former spouse, this alimony would qualify as a type of unearned income.
- Inheritance: If you receive an inheritance then this could qualify as income, which would be unearned.
- Retirement account income: If you receive money from a 401(k), IRA or another retirement account, then this qualifies as unearned income.
- Dividends: A common income that comes from investments are dividends. These can be taxed either as ordinary income or as a long-term capital gain.
- Rental Income: Income generated from real estate properties that you own and rent to others.
- Royalties: Payments received for the use of intellectual property, such as patents, copyrights, or trademarks.
- Capital Gains: Profit earned from the sale of investments, real estate, or other assets that have appreciated in value.
- Annuities: Regular payments received from annuity contracts, often purchased for retirement income.
Types of Earned Income
Earned income includes money that is earned through active participation in work or a business. Some common types are:
- Wages and salaries: Compensation for work performed as an employee, often paid on an hourly or salaried basis.
- Self-employment income: Income earned by individuals who work for themselves as freelancers, independent contractors, sole proprietors, or business owners.
- Bonuses: Additional payments or incentives provided to employees based on performance, company profits, or other criteria.
- Commissions: Compensation paid to salespeople, agents, or brokers for the sale of products or services.
- Tips and gratuities: Additional income received by employees in service industries, such as waitstaff and bartenders.
- Severance pay: Compensation provided to employees who are laid off, terminated, or leave a company under certain conditions.
- Overtime pay: Additional compensation for employees who work more than their regular work hours, often at a higher hourly rate.
- Earnings from business activities: Profits generated by individuals who own and operate businesses, including sole proprietorships, partnerships, and corporations.
- Consulting fees: Income earned by individuals who provide expert advice or services as consultants.
Benefits of Earned Income vs. Unearned Income
Earned income provides immediate cash flow, contributes towards Social Security and Medicare and often comes with benefits like health insurance and retirement contributions from employers.
This type of income is generally more stable and predictable than unearned income, providing a solid financial foundation. However, it doesn’t mean that it should be your only source of income.
Unearned income offers a way to grow wealth through investments with potential tax benefits.
Its role in wealth accumulation should not be undermined, especially for those who can afford to invest significant amounts.
Having a nice variety of income types can help diversify your risk and grow your wealth steadily over time.
Bottom Line
Understanding the distinction between earned and unearned income provides a strong basis for effective financial planning. It shapes your tax planning, investment strategies and retirement planning. Diversifying income sources and strategically managing both earned and unearned income can help you ensure financial stability.
Tips for Tax Planning
- A big part of deciding between your type of income is your tax liability. A financial advisor can help you prepare for your taxes and plan out how you should manage your own income to best benefit. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you canhave a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- To estimate what your tax liability might be, consider using SmartAsset’s free federal income tax calculator.
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