What is 'Unearned Income'
Unearned income describes any personal income that comes from investments and other sources unrelated to employment services. Examples of unearned income include interest from a savings account, bond interest, alimony and dividends from stock. This type of income differs from traditionally earned income, which is the income earned from active work or business activity.
BREAKING DOWN 'Unearned Income'
Unearned income is a type of income denoted by the IRS derived from means other than personal efforts. To the IRS, "personal efforts" includes wages, salaries, tips, other taxable employee pay and self-employment income. Any income source that falls outside of these efforts is considered unearned income. This type of income is commonly denoted as "passive sources of income" and is generated without having to work.
Most unearned income sources are not subject to payroll taxes, and all unearned income sources are not subject to employment taxes, such as Social Security and Medicare. It is therefore extremely important for individuals making unearned income to understand where that income is coming from and how each source is taxed.
Types of Unearned Income
The most common type of unearned income is the income that comes from interest and dividends. Most people participate in some sort of investing, either debt or equity. If, for example, a person invests in a dividend-paying company such as Disney, he most likely receives a dividend payment every quarter. This means each stock the investor owns receives a percentage of the company's profits each quarter, known as the dividend yield. The total sum of the dividend yield is taxed at the current dividend tax rate. The money earned in this capacity is considered unearned income, and the tax paid is considered unearned income tax.
Retirement benefits are also a common type of unearned income. When a person retires, he most likely lives off of the distributions from a 401(k), pension or similar retirement account. Specifically in the case of a 401(k) distribution, where taxes are realized when the money is withdrawn, the IRS considers the withdrawn money to be unearned income. The retiree is taxed at his income tax rate in this scenario.
Less common forms of unearned income include gifts, prizes, inheritances and other unearned income. Any time someone gifts money to another person, wins prize money in a contest or lottery, inherits money from a deceased relative or receives alimony or workers comp, it is considered unearned income. This is because the money was generated without the involvement of active work or business activity. Each of these situations has unique unearned income tax rates.