What is the Difference Between Earned and Unearned Income?

By Patricia L Johnson

A few months ago my partner and I, Richard Walrath, wrote an article on Income Mobility and a reader recently sent us an inquiry on the subject.

After a couple e-mails back and forth it finally occurred to me this reader was not completely aware of the difference in Earned and Unearned Income and I started wondering if other people are also confused on the subject.

Earned Income is any income derived from employment for services rendered.    If you are a contractor build a house, and get paid for your services, that is earned income.  If you are a contractor, get an advance payment for building the house, that is unearned income, once you build the house the unearned income then becomes ‘earned’ income.

Other forms of unearned income are civil service annuities, workers’ compensation, unemployment compensation, life insurance proceeds (over and above the cost of the deceased last illness and burial), gifts, support and alimony (either in cash or in-kind), prizes and awards, dividends and interest, rents and royalties (except those considered earned income), Social Security benefits, Railroad Retirement benefits, Department of Veterans Affairs pension and compensation payments, private pensions and annuities.

I used gifts as an example of unearned income in my e-mails, and I’ll use it here also as there are probably many people that aren’t fully aware of what a neat treat the IRS gave us in the form of gift tax exclusions. 

The following is from IRS publication 950

For Gift Tax Purposes the following are applicable:

Year:   2007, 2008 – Annual Exclusion:  $12,000

*Unified Credit Amount:  $345,800 – Applicable Exclusion Amount:  $1,000,000

Unified Credit (Applicable Exclusion Amount) A credit is an amount that eliminates or reduces tax. The unified credit against taxable gifts will remain at $345,800 (exempting $1 million from tax) through 2009.

Generally, the following gifts are not taxable gifts:

Gifts, excluding gifts of future interests, that are not more than the annual exclusion for the calendar year,

Tuition or medical expenses you pay directly to a medical or educational institution for someone,

Gifts to your spouse,

Gifts to a political organization for its use, and

Gifts to charities.

Here are a few examples:

Example 1.    In 2007, you give your niece a cash gift of $8,000. It is your only gift to her this year. The gift is not a taxable gift because it is not more than the $12,000 annual exclusion.

Example 2.    You pay the $15,000 college tuition of your friend. Because the payment qualifies for the educational exclusion, the gift is not a taxable gift.

Example 3.    In 2007, you give $25,000 to your 25-year-old daughter. The first $12,000 of your gift is not subject to the gift tax because of the annual exclusion. The remaining $13,000 is a taxable gift. As explained later under Applying the Unified Credit to Gift Tax, you may not have to pay the gift tax on the remaining $13,000. However, you do have to file a gift tax return.

Please click the following link to read complete publication from the IRS.


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