The difference between earned and capital income is based largely on where the money came from. Earned income typically refers to money that an individual obtained by doing specific work, such as an hourly wage or salary from a job. Capital income is usually defined as money produced by the investment of preexisting wealth. Some common types of capital income include stock dividends, the proceeds of investments, and any pass-through income an individual receives from a business he owns. These distinctions are often made for taxation purposes because earned income may be treated differently from unearned sources.
Earned income is money that can be associated with performing a specific job or action and then being compensated for it. An hourly wage or salary from a job is considered to be earned income, but tips and other sources of money can be earned income as well. There are also some exceptions depending on the particular jurisdiction. In the United States, for example, alimony can be considered a form of earned income.
Capital income is a type of unearned income that is often differentiated for taxation purposes, and is usually the result of an investment or similar action. In this case it is the capital, or wealth, that is doing the work. Interest that is earned on a savings account or certificate of deposit (CD) can be considered capital income because no work was done by the owner of the money to realize that profit.
Another type of capital income can be passed through to an individual from a business that he owns. In the case of an S corporation or certain limited liability companies (LLCs), income from the businesses passes through to the owners. This type of income is usually considered passive as opposed to the earned income the owner would receive if he worked for the company and had a regular salary. Capital gains is another type of unearned income that can result from the sales of appreciated real estate, financial instruments, and other items.
One of the reasons that earned and unearned income are often differentiated is for taxation purposes. These different kinds of income are often taxed at different rates, which can have the effect of encouraging or discouraging capital investment depending on the particular rate structure. In the United States, you may also be unable to contribute to certain tax deferred plans, such as individual retirement accounts (IRAs), in years that you have no earned income.