Is Your Income “Earned Income” or “Unearned Income”?

As the year draws to a close, and as you are (hopefully) beginning to gather your tax documents, don’t forget that you need to be able to identify what type of income you are dealing.

The IRS makes it clear that it considers earned income different from unearned income. Indeed, in some cases your unearned income is taxed differently from your earned income. And, starting in 2013, your unearned income will make more of a difference, since there will be a Medicare surtax added to unearned income for those making above a certain amount of money each year.

Understanding the difference between earned income and unearned income is important as you fill out your tax forms, since you will need to claim the income in specific places on your forms.

Earned Income

For your income to be termed “earned,” you have to do something for it. You offer products or services or work in exchange for money. If you have a home business, or if you work for someone else in a more traditional setting, you have earned income. Also, understand that any tips that you receive, on top of wages, are also reported as income. True alimony is categorized as earned income, but child support isn’t.

All of your earned income should be added up and reported on your tax form. It’s fairly straightforward, for the most part. However, some of the definitions can get fuzzy if you have complicated finances, including real estate rentals and businesses that you no longer run.

Unearned Income

This type of income is characterized as money you receive without having to do active “work” in order to receive it. The IRS has some income sources that are specifically considered unearned:

• Interest
• Capital gains
• Dividends
• Retirement account distributions
• Social Security benefits
• Some real estate income (if you don’t meet the designation as a “real estate professional”)
• Debt forgiveness
• Winnings from gambling
• Compensation for unemployment
• Income from a business or trust in which you benefit, but do not actively participate in

In some cases, the line can get a blurry. It’s a good idea to consult with a tax professional if you have questions. All of your income, earned or unearned, is supposed to be reported to the IRS. And some of it might be taxed differently. A good example is that of long term capital gains. There is a different tax structure in place for long term capital gains, and if you are in a higher tax bracket, you could see tax savings due to these differences.

If you are interested in the definitions of “real estate professional” or “material participant” in a business, you should also consult with a tax professional. You might be able to keep from having your income classified as unearned if you meet minimum requirements to have it seen as earned income. This might not be a big deal right now, but later it might matter if you can avoid the surtax on unearned income by making a few changes to ensure that you have a little more earned income.