Sources of unearned income that allow income taxes to be deferred include 401 (k) plans and annuity income. Traditional 401 (k) plan withdrawals are considered income (regardless of age). However, you won't pay capital gains taxes on these funds. Your 401 (k) plan withdrawals are not counted as earned income.
Likewise, your Social Security income is not considered earned income either. In reality, neither 401 (k) plan distributions nor Social Security benefits qualify as earned income because they are not derived from wages you earn while working for someone else or running your own business when you receive them. It's important to note that IRA contributions can only be made with earned income. If you have an IRA, but over the course of a year you don't get any earned income and instead subsist on unemployment benefits and gambling profits, you won't be able to make a contribution to your IRA during that year.
Likewise, while children can have IRAs, they can't fund them with money for their birthdays and allowance. However, if they make money taking care of children or walking dogs, that is earned income and may qualify for IRA contributions. Interestingly, alimony counts as earned income for the purposes of IRA contributions, even though it is considered unearned income for your taxes. Unearned income is generally taxed differently than earned income or business profits.
The tax also varies depending on the types of unearned income. You're generally exempt from paying payroll taxes and other employment taxes, such as Medicare and Social Security. On the other hand, unearned income could be subject to capital gains tax. Some of these types of income are also completely tax-free, for example when paying for life insurance.
