Earned income refers to the wages, salaries, tips, and other taxable employee pay that you receive from active participation in a business or occupation. This encompasses income from self-employment, commissions, and freelance work.
Examples of Earned Income
- Wages and Salaries: Regular paychecks from an employer.
- Self-Employment Earnings: Profits from a personal business or freelance work.
- Commissions: Earnings based on sales or services rendered.
- Bonuses and Tips: Additional compensation for excellent performance or services.
Earned income typically involves personal effort and active work. It’s often subject to payroll taxes and is included in Social Security calculations.
Understanding Unearned Income
Unearned income, on the other hand, is income received from investments, pensions, and other sources not directly resulting from labor or active work. Examples include interest, dividends, capital gains, pensions, and rents.
Examples of Unearned Income
- Interest and Dividends: Returns from savings accounts, stocks, and bonds.
- Capital Gains: Profit from the sale of investments or property.
- Rental Income: Earnings from leasing property.
- Pension Payments: Income from retirement plans.
Unlike earned income, unearned income does not require active work and is not subject to payroll taxes. However, it may still be taxable and subject to different tax rules.
Importance in Taxation: The Kiddie Tax
The distinction between earned and unearned income becomes particularly significant in the context of the Kiddie Tax. The Kiddie Tax applies to unearned income of children under certain circumstances and is designed to prevent families from shifting large amounts of income to their children to take advantage of their lower tax rates.
Key Points about the Kiddie Tax
- Applies to children under 19 (or under 24 if a full-time student).
- Targets unearned income exceeding a certain threshold.
- Unearned income above the threshold is taxed at the parents’ tax rate.
Comparisons and Special Considerations
Comparisons
- Effort and Participation: Earned income requires active participation, while unearned income does not.
- Tax Treatment: Both types of income are taxable, but they are subject to different tax rules and rates.
- Sources: Earned income comes from employment or business activities, whereas unearned income comes from investments and other passive sources.
Special Considerations
- Tax Planning: Understanding the differences can aid in effective tax planning and compliance.
- Investment Strategies: Choosing between active employment and investment income affects tax obligations and financial planning.
Related Terms with Definitions
- Capital Gains: Profit from the sale of an asset held for investment purposes.
- Dividends: Distribution of a portion of a company’s earnings to shareholders.
- Interest Income: Earnings from interest-bearing accounts or investments.
- Self-Employment Income: Earnings from operating a business or trading as a sole proprietor.
FAQs
What distinguishes earned income from unearned income?
Why is the difference important for tax purposes?
How does the Kiddie Tax affect unearned income?
Are Social Security benefits considered earned or unearned income?
Summary
Understanding the distinction between earned and unearned income is essential for tax planning and compliance. Earned income, derived from active work, and unearned income, sourced from investments and savings, are taxed differently and have distinct implications for various tax rules, including the Kiddie Tax. Recognizing these differences helps individuals manage their finances more effectively and anticipate their tax liabilities.
References
- Internal Revenue Service (IRS): Publication 929, “Tax Rules for Children and Dependents”
- Investopedia: Earned Income and Unearned Income
- Tax Policy Center: Understanding the Kiddie Tax
