Unearned income vs. earned income: Key differences + tax nuances

Have you ever wanted your money to work for you? Unearned income is exactly that. It flows in without you needing to clock in or even be present at a job. Unlike the wages you earn from employment, unearned income usually comes from investments, alimony, or other sources. 

According to a recent QuickBooks survey, 78% of small businesses are looking to expand in 2025. If you’re a part of this group, understanding unearned income can help you get closer to your growth goals.

Let’s look at some of the nuances of unearned income, the most common types, and how it differs from earned income.

Jump to:

• What is unearned income?
• What is the difference between earned and unearned income?
• 5 common types of unearned income with examples
• The benefits of unearned income
• Is unearned income taxable?
• How to report unearned income
• Streamline your accounting and save time

What is unearned income? 

Unearned income is any money you make without providing a service or product. It is also known as "passive income" because it comes from assets you own, not from your labor.

Some unearned income examples include interest in a savings account, investment gains in stocks or cryptos, lottery winnings, or similar income sources. 

We can break down unearned income into a few key categories:

• Investment income: This is money generated by your financial assets. It includes interest from savings accounts and bonds, stock dividends, and capital gains from selling investments.
• Winnings: If you hit the jackpot, whether from the lottery or gambling, those winnings are considered unearned income.
• Rental income: The money you collect from tenants for renting out a property is a classic example of unearned income, as you are not actively working to earn it daily.
• Pensions and Social Security: Payments from retirement accounts, pensions, or Social Security benefits are a vital form of unearned income, especially for retirees.
• Unemployment and alimony: Other sources, like unemployment compensation and alimony, also fall into the category of unearned income.

This is all different from earned income, which includes wages, salaries, and tips you get for working a job.

What is the difference between earned and unearned income?

At a basic level, the fundamental difference between earned and unearned income lies in how the money is generated. Is it the result of your direct work and effort, or did you receive it passively from an asset? 

For small business owners, understanding this distinction is key to accurate financial reporting and tax compliance.

Earned income

Earned income is money you receive in exchange for providing a service or performing labor. It's sometimes called "active income" because it requires your direct participation.

This type of income is generally subject to federal and state income taxes. It's also where payroll taxes,like Social Security and Medicare,come into play.

Examples: The most common examples for small business owners are wages, salaries, commissions, and earnings from self-employment. If you're a freelance graphic designer, the money you get from a client for a completed project is earned income.

Why does the earned income distinction matter? 

The Internal Revenue Service (IRS) uses the earned income distinction for more than just a classification system; it can directly affect your eligibility for tax credits and your ability to save for retirement.

For example, the Earned Income Tax Credit (EITC) is specifically designed to benefit low-to moderate-income workers. Eligibility limits apply to both investment income (unearned) and all earned income. The amount received is based on factors other than income; eligibility is based on both earned and unearned income.

Also, to contribute to a traditional or Roth IRA, you must have earned income. Unearned income, such as investment gains or rental profits, can't be used for these contributions.

5 common types of unearned income with examples

The IRS identifies many types of unearned income, but most fall into these broad categories: 

• Interest
• Dividends
• Capital gains distributions
• Rental income
• Inheritance

Let’s look at each one closer.

Interest 

One of the most common answers to the question “What is unearned income?” is “interest.” At the consumer level, this could be an annual rate your bank pays you on your savings account balance or a certificate of deposit. 

A business may have more ways to earn interest. For example, one company could earn interest on the funds held on behalf of another company for operating costs such as payroll.

Dividends

One answer to the question “What is unearned income?” deals with an often overlooked aspect of stock market investing: dividends. When you buy even a single share, you become a part-owner of that company, a shareholder. 

You’re now entitled to a share of the company’s earnings and will receive dividends. These are distributions of earnings based on the number of shares you own. Not all stocks pay dividends, so research before investing.

Capital gains distributions

Instead of buying a company’s stock directly, as Sean did in the example above, you could buy shares in a mutual fund for diversification purposes. If the fund sells a portion of its stock holdings at a profit, it’ll pay you your share. Think of it as a type of dividend. The official term is “capital gains distribution,” a profit made from selling an investment—and another answer to the question “What is unearned income?”

Rental income

Rental profit might not come to mind when you hear “unearned income”—but that’s what it is.

Since time immemorial, renting out land and housing has made lots of people very wealthy. Even renting out a small part of your property—like a single room—can make a big difference in your monthly budget.

Inheritance

Another old-fashioned way of acquiring wealth is by inheriting it. Around the world, the wealthy have complained about inheritance taxes for decades. Their argument is not unreasonable: “Our money was already taxed once when we made it, so why tax it again when we pass it on?” 

But because the heirs don’t provide a service to earn the money, inheritance falls squarely in the “What is unearned income?” category.

The benefits of unearned income

You can use those funds in many practical ways:

• Supplement your primary income for everyday expenses
• Increase your retirement account contributions
• Contribute to your kids’ college fund
• Pay extra on your mortgage every month to reduce the principal
• Pay off credit cards, car loans, or student debt
• Support a charity

Is unearned income taxable? 

Unearned income is taxed, though it’s often at lower rates than ordinary earned income. For instance, long-term capital gains and qualified dividends may be taxed at rates of 0%, 15%, or 20% for individual taxpayers, depending on their income bracket.

This contrasts with ordinary income, which can be taxed at rates as high as 37%. Other types of unearned income, such as interest and rents, are taxed at your regular income tax rate.

Some tax implications of unearned income include:

• Lower tax rates than earned income: Some types of unearned income are taxed at 0% under certain conditions, e.g., below certain income thresholds.
• No payroll taxes: Unearned income is not subject to Medicare and Social Security contributions.
• Reported with adjusted gross income: On the IRS forms, you’ll report unearned income with earned income.

How to report unearned income

Reporting unearned income depends on whether you're filing as a business or individual, as the terminology and accounting principles differ.

How to report unearned income for Individuals

For individual taxpayers, unearned income is reported on your personal income tax return, Form 1040. You report your total income, including both earned and unearned sources. You'll typically receive tax forms, like a Form 1099, from the institutions that paid you unearned income—for example, a bank for interest or a brokerage for dividends.