You are financially prudent to have a full view of all of your various income sources, including employment and other types of earnings for any given month. You need to know this information for budgeting and other general financial decision-making tasks. You must also differentiate between earned and unearned income. Knowing the type of income you bring in is particularly important in advance of doing your taxes.
Earned income is the amount you make due to active participation in a task. With earned income, you exchange physical work or a service for money. You can make earned income as an employee of another business or as a self-employed individual who owns his own business. Earned income includes basic wages, tips, commission payments and profits you receive from the operation of your own company.
Unearned income is money that you take in passively. With passive income, you do not work for the money; it comes in without any required physical activity on your part. One of the most common types of unearned income is interest income or dividends from an investment. Other types include real estate rents, child support, unemployment earnings, supplemental security income (SSI), lottery winnings and income from a business that you didn’t actively participate in (such as a silent partnership arrangement).
The type of income you’ve gathered during the year matters for tax reasons. Whether the income is earned versus unearned matters when you have to determine certain income exclusions, deductions and credits. For instance, the earned income credit (EIC) is only extended to people who have made money from an occupation in which they have actively worked. Also, to contribute to an IRA and deduct IRA contributions you need to have earned income for the year.
Regardless of whether the income is earned or unearned, it is reported in the “Income” section of your Form 1040. If all you have is unearned income and another person claims you as a dependent, you might not have to file a tax return for that year depending on the amount. Consult with a tax advisor if you’re unsure of whether filing is necessary.