Unearned income is Uncle Sam’s way of saying there’s another way to make money other than actively working for it.

Basically, unearned income is money earned without any “active” work linked to it, and also goes by the name “passive” income as a result.

What kinds of personal financial activities qualify for unearned income and what is the tax difference between unearned (“passive”) income and earned (“active”) income? Let’s take a deep dive on unearned income and see why it matters so much to investors, investment firms, and government interests.

What Is Unearned Income?

The IRS defines unearned income in the following way:

“Unearned income includes investment-type income such as taxable interest, ordinary dividends, and capital gain distributions.”

“It also includes unemployment compensation, taxable Social Security benefits, pensions, annuities, cancellation of debt, and distributions of unearned income from a trust.”

In plain talk, that means income that has no direct link to a paycheck, earned from active employment. As the IRS notes, it’s primarily cash that’s earned from investments, but it could also be garnered from non-investment activity, such as a family inheritance or alimony after a divorce.

Here’s a complete list of sources of unearned income:

  • Investment income
  • Dividend income
  • Capital gains and capital gain distributions
  • Retirement income, such as cash earned from company pensions, annuities, and 401k plan or IRA account withdrawals
  • Social Security benefits (partially taxable)
  • Unemployment benefits
  • Alimony
  • Child support
  • Some distributions from trusts
  • Gambling and lottery winnings
  • Forgiven debts
  • Select forms of real estate income

Even income that at first glance appears to have come from active work, like working in a prison, is considered to be unearned income in the eyes of the federal government.

Additionally, any income received from even an indirect involvement with an estate, trust, S corporation, or other business partnership, may be taxable as unearned income by the IRS.

Earned income is viewed differently than unearned income for tax purposes. Here’s a list of common form of earned income sources.

  • Professional fees earned by an individual or commercial enterprise.
  • Tips earned in the services sector
  • Wages earned on the job
  • Self-employment income, which is recorded tax-wise, on an IRS 1099 form.
  • Commissions earned on the job, usually in the sales sector.
  • Bonuses earned on the job, like a Wall Street broker earns for meeting or exceeding company sales/revenue expectations, for example.
  • Sick leave on the job (yes, getting the flu has a financial impact, according to the IRS.
  • Personal time-off pay taken by employees.
  • Long-term disability benefits again garnered from full or part-time employment.
  • Meal, transportation, and accommodation reimbursement from employees traveling on the company dime.
  • Non-cash income earned on the job, such as a vehicle provided to a traveling salesperson by his or her company.

A Closer Look at Unearned Income vs. Earned Income

To understand the difference between unearned income and earned income, you need to understand the meaning of “income” on its own.

Primarily, income is defined as monetary assets earned, primarily through the act of working for a company or organization, or by working for yourself. Or it can be earned indirectly, through financial vehicles like investments, trusts, and wagering, among other examples (listed above.)

Let’s put it this way:

Earned Income – This is the cash you receive from performing a service or a type of work, usually via employment. For example, if you earn $50,000 as a firefighter, the paycheck you draw is a prime example of earned income.

Unearned Income – This is cash you receive in the absence of active work or in providing a commercial service. For example, if you’re that firefighter who earns $50,000 in salary, you also likely get a pension or retirement fund as a benefit. Any money earned from those vehicles, not included in a paycheck, is a prime example of unearned income.

That difference is particularly important for tax purposes, as in most cases, earned income and unearned income are taxed differently.

  • Earned income is subject to federal, state, and in some cases, city income tax. Additionally, earned income also triggers a payroll tax. 
  • Unearned income is taxed under the category of adjusted gross income in IRS statutes, but is not linked to a payroll tax.

Tax Differences

Tax-wise, earned income and unearned income are taxed differently because of their unique income classifications and taxpayers should be aware of tax-related distinctions between the two.

Taxes on Earned Income

With earned income, a worker pays two primary classes of taxes – traditional federal and state (and sometimes city) taxes and Social Security and Medicare taxes, better known as payroll taxes.

With the latter, the government has a standard formula for determining how much money is taken out of your paycheck to steer towards Social Security and Medicare. For traditional workers, 12.4% is deducted from your paycheck to cover the Social Security portion of payroll taxes – you pay 6.2% and your employer pays 6.2%.

If you’re a 1099-based self-employed worker, you pay the entire 12.4% yourself.

The deduction is based on what the federal government calls a “contribution and benefit base”, which amounts to $137,700 in 2020. That’s the amount of income a worker receives up to a fixed dollar limit (i.e., the $137,700.) The government will not deduct a payroll tax above the benefit base limit.

Uncle Sam also deducts 2.9% from a worker’s paycheck as a Medicare payroll tax. With traditional career professionals, that figure is split in half at 1.45%, each covered by the employer and the employee. Also again, a self-employed professional covers the entire 2.9% Medicare deduction.

There is no earnings cap with the Medicare payroll tax.

Taxes on Unearned Income

Unlike earned income, unearned income isn’t subject to payroll taxes.

That is a benefit of unearned income, but you're not out of the woods yet. That’s because the IRS deems unearned income to be bundled into a taxpayer’s adjusted gross income (a taxpayer’s income minus deductions.)

A trusted accountant can help figure out your AGI liability and include it on your tax returns (on line 37 of your federal 1040 tax form.)

Otherwise, unearned income is levied at the taxpayer’s marginal tax rate, i.e., the rate of your taxes paid at each federal tax bracket.

In some cases, certain classes of unearned income, like stock dividends and capital gains, are taxed at a lower rate. Once again, a good accountant or tax professional can help you maximize your tax savings in these categories.

Examples of Earned and Unearned Income

Let’s take the comparison between earned and unearned income a level deeper with a real world scenario – a marketing director who works at a high end corporation in New York City.

Our marketing professional, her name is Gina, earns $175,000 annually as a marketing decision-maker at this high-end company.

But Gina has a side-hustle – she invests in short-term stock market plays in her spare time. It excites her, she’s proven good at it, and she earns an additional $25,000 annually as an online stock trader. She also puts $15,000 into her company 401(k) plan on a tax-deferred basis every year.

In this scenario, Gina’s earned income is $175,000 and her unearned income, in the short-term, is the $25,000 made as a part-time stock trader. Any income earned from her 401(k) investment also has to be listed on her tax returns, and is also deemed to be unearned income.

The Takeaway on Unearned Income

Accumulating wealth through unearned income should certainly be a goal of any financial consumer. Leveraging investments, workplace benefits and bonuses, and “one-offs” like an inheritance or a lottery win is a great strategy, wealth creation-wise.

Just know that the federal government will treat the tax liability of unearned income differently, and will, through the IRS, keep a close eye on just how much unearned income you’re earning.