Filing a tax return can be a complicated process, especially if you have multiple sources of income. The Internal Revenue Service taxes you at different rates depending on the types of income you have: income that is considered earned faces different tax rules than investment income. In general, earned income is compensation you get from working, while investment income describes returns you receive on savings and other assets.
TL;DR (Too Long; Didn't Read)
Earned income is the pay you receive for operating a business or working a job, while investment income includes earnings from money invested or properties that generate a profit. They come with different tax implications, and some forms of income fall outside these two.
Earned income describes cash and other forms of pay you receive for doing a job or running your own business. If you don't have a job, work as a contractor or run a business, you don't have earned income. According to the IRS, earned income is limited to wages, salaries, tips, union strike benefits, net earnings from self-employment and long-term disability benefits received prior to minimum retirement age. You can choose to have nontaxable combat pay included in earned income for the purpose of claiming an earned income tax credit. Earned income is subject to Social Security tax and income tax.
When you save money at banks or buy property that generates an income stream or profit, you have investment income. According to the IRS, investment income includes interest, dividends, capital gains, rents, royalties and non-qualified annuities. Investment income is not subject to Social Security tax and certain types of investment income, such as capital gains and dividends, are taxed at lower rates than earned income. In 2013, a net investment income tax of 3.8 percent went into effect and applies to investment income if your modified adjusted gross income is $200,000 or more as a single taxpayer and $250,000 or more as a joint filer. The net investment income tax applies in addition to normal income and capital gains taxes.
If you want to stash cash in an individual retirement account, you need to have taxable compensation. Taxable compensation is similar to earned income, in that wages, salaries, commissions and self-employment income all count. On the other hand, alimony and separate maintenance payments you receive are also considered taxable compensation, despite not being a form of earned income.
Other Types of Income
Certain types of income don't fit into the category of earned income or investment income. For example, Social Security benefits, unemployment benefits, alimony, child support and gambling winnings are not earned and do not arise from making investments. Retirement income, such as money you withdraw from a 401(k) or IRA is generally not considered investment income for tax purposes, even though you can use the funds in a retirement account to purchase investments.