The Internal Revenue Service draws a distinction between two basic types of income for tax purposes: earned income and unearned income. Earned income is money you make through employment or running a business, such as wages, salaries, tips and business profits. Unearned income by definition describes passive sources of income that you gain without having to work. Some unearned income, but not all, is subject to income tax; it is not, however, subject to payroll taxes – that is, Social Security and Medicare taxes.
What's Unearned Income?
When you save money at a financial institution such as a bank or credit union, your account may accrue interest over time, which is credited to your account. Similarly, when you buy stocks, you may receive cash payments called dividends from the corporation that issued the stock, simply for being a shareholder. Both interest income and dividends are considered forms of unearned income for tax purposes. They're some of the most common unearned income examples for taxpayers to receive.
Retirement typically marks an end to having earned income, so retirees tend to rely on variety of sources of unearned income. Retirement income, such as money you receive from a company pension, payments received from an annuity and money you withdraw from a retirement account are forms of unearned income. Social Security benefits are also a form of unearned income.
Essentially any sum of money or property you receive without working for it is considered a form of unearned income. If someone gives you a gift of cash or property, the gift is unearned income, though any tax on gifts is paid by the person giving the gift, not the person receiving it. Similarly, unearned income also includes inheritances, awards, prizes and money gained from gambling.
Unearned income includes a variety of other income sources that do not involve active work or business activity. Other types of unearned income include alimony, child support, workers' compensation, unemployment benefits and pay received as an inmate at a penal institution.
IRAs and Unearned Income
The distinction between earned and unearned income can have important tax implications. For example, you can only contribute to an IRA if you have earned income. Even if you have sufficient unearned income to live on, and want to save some for retirement, you cannot use an IRA to do so – and to take advantage of the tax benefits and IRA provides – unless you have some earnings.
If you are married, you are allowed to take your spouse's earned income into consideration for IRA contribution purposes.