The IRS has defined two specific types of income: earned and unearned. Understanding the differences between the two is necessary for paying federal and state income taxes. You'll also need to know whether your income is earned or unearned if you wish to take advantage of certain tax-deferred investments.
Whether your income is earned or unearned depends on its source. Earned income is money that you receive in exchange for work that you are actively doing. Unearned income is any other type of money that you receive. You may have both earned and unearned income from several sources. Both types of income factor into your gross income, the amount of which determines whether you must pay federal and state taxes and the rate you must pay.
Unearned Income Examples
Any type of money received from an investment is, by the IRS' definition, unearned income. This includes interest from CDs and dividends from stock market investments. Monthly payments from annuities and distributions from a trust or individual retirement accounts also fall under the category of unearned income. Although social security and unemployment benefit funds accumulate based on deductions taken from your paychecks and credits you earn through working, payments from both are considered unearned income. Pension payments are also unearned.
Earned Income Examples
Regular wages paid in weekly, biweekly, monthly or one some other regular basis are the most common form of earned income. In addition, tips paid to you by clients and bonuses paid to you by your employer qualify as earned income, along with any commissions that you make. Professional fees that you earn from clients for completing your work should also factor into your earned income. Because the primary work of students is attending classes, taxable scholarships and fellowships to cover tuition and provide living expenses are earned income; however, not all scholarships and fellowships are deemed as taxable. Disclosures given with awards typically discuss their tax implications, if any.
Examples of the Importance
Whether your income is unearned or unearned becomes important if you are considering opening an individual retirement account; the IRS only allows individuals with earned income to contribute to IRA accounts. Unearned income becomes important when determining if a minor must pay federal income taxes. For most single dependents under 65 years of age, having unearned income of $2,350 or more results in the need to file even if they are not working at a job.