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The IRS taxes various kinds of income. You may have heard the terms “earned income” and “unearned income” before and wondered what the differences are. In this article, we’ll discuss what these are, how these are taxed, how to report them on your tax return and more.
First, let’s explore definitions. Earned income is what you receive from actively working. It includes wages, salaries, and self-employment income. Unearned income is from anything other than work, unemployment, retirement, investments, etc.
Unearned includes investment-type income such as taxable interest, ordinary dividends, and capital gains distributions. It also includes unemployment compensation, taxable Social Security benefits, pensions, annuities, cancellation of debt, and distributions of unearned income from a trust. There are other examples. If you have questions about whether you have unearned income, reach out to a local Tax Pro.
What are the three types of income?
There are three main categories of income: earned or active income, unearned or passive income, and portfolio income. We’ll be focusing on the differences between earned (active) and unearned (passive) income in this article.
Passive or unearned income is the other side of the “active or earned income” coin, which is income you receive from a job or business venture that requires active participation. As with active income, passive income is taxable.
It’s important to note that some tax breaks depend on you having at least some earned income. Not having earned income can disqualify you from a number of tax breaks. We’ll go into more detail on that below.
What is earned income?
Earned income is also called “active income” because you are actively involved in the work to earn the money. If you work for a company—from a small business to a large corporation—your employer may pay you a wage based on the amount of time you work, or a salary based on the position you have within the company. You may also be self-employed. Perhaps you are a delivery driver, or own a small business, or freelance. When you’re performing a service and then getting money for that service, it’s earned income.
What is unearned income?
Unearned income is also called passive income. According to the IRS, unearned income includes investment-type income such as taxable interest, ordinary dividends, and capital gains distributions.
It may also come in the form of unemployment benefits, taxable Social Security benefits, pensions, annuities, cancellation of debt, and distributions from a trust.
Unearned income tax
Unearned income is generally taxed at the same rate as salaries received from a job, but certain types of unearned income, known as capital gains, are taxed at much lower rates than your regular income. You’ll want to work with a Tax Pro to get a full view into your entire financial picture. As with earned income, it’s possible to use deductions to lessen the tax you pay.
It’s important to note that the IRS has standards of material participation to differentiate between unearned and earned income. Your Tax Pro can go into these more in-depth to make sure that you’re reporting the correct type of income.
These are some key examples of what the IRS calls “material participation.” At this point, the IRS would consider it “active income,” and tax accordingly:
- If you’ve dedicated more than 500 hours to a business or activity from which you’re gaining income.
- If your participation in an activity has been “substantially all” of the participation for that tax year.
- If you’ve participated up to 100 hours, and that is at least as much as any other person involved in the business.
Earned income vs. gross income
Gross income is the entire amount of money an individual makes, including wages, salaries, bonuses, and capital gains from your investments. Adjusted gross income (AGI) is your gross income after accounting for deductions and adjustments.
Net income is the amount an individual or business makes after deducting costs, allowances, and taxes. For businesses or companies, it is the total earned income and sales of a business or company, minus expenses such as cost of goods sold, general and administrative expenses, operating expenses, depreciation, interest, and taxes. It’s sometimes called net profit.
One key difference is that net income is used for both businesses and individuals, while AGI is only applicable to individuals.
Example of an unearned income
There are many types of unearned income, especially in the age of social media and the internet. Below are just a few examples:
- Rental income: This is one of the most common types of passive income. Renting out a garage, room, or a house or apartment. This can be a short-term or longer-term arrangement. This may also include renting out part of your house for other people to use for storage.
- S corp. Owning shares in an S-corporation due to an investment in the business is generally passive income. Receiving royalties each time your book is sold after the initial sales.
There are many more examples. If you are thinking of starting to earn passive income, talk to your Tax Pro about making sure that you’re reporting the income accurately.
Benefits of unearned income
There are some benefits to unearned income. Sources of unearned income that allow a deferment of income tax include 401(k) plans and annuity income.
How to report unearned income on your tax return
As mentioned, passive income can make filing your taxes more complicated. There are some good rules of thumb to follow when you have passive income.
- You should always keep all pertinent documents and ensure that you have all your income statements and the associated expenses for your Tax Pro to work with.
- Grouping activities can help make the process a little bit easier. For example, the IRS allows multiple trade, business, or rental activities to be grouped into a single activity if they form “an appropriate economic unit.” An appropriate economic unit can be based on a variety of factors, including:
- The similarities and differences in the types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- The geographical location; and
- The interdependencies between or among activities.
As always, you’d want to work closely with a Tax Pro and make sure that these are grouped accurately. Find a local tax professional near you today.
About the Author
Mark Steber is Senior Vice President and Chief Tax Information Officer for Jackson Hewitt. With over 30 years of experience, he oversees tax service delivery, quality assurance and tax law adherence. Mark is Jackson Hewitt’s national spokesperson and liaison to the Internal Revenue Service and other government authorities. He is a Certified Public Accountant (CPA), holds registrations in Alabama and Georgia, and is an expert on consumer income taxes including electronic tax and tax data protection.