What Is Unearned Income?
Unearned income is income from investments and other sources unrelated to employment. Examples of unearned income include interest from savings accounts, bond interest, alimony, and dividends from stock. Unearned income, known as a passive source of income, is income not acquired through work.
- Unearned income is income that is not earned, meaning it is derived from another source, such as an inheritance or passive investments that earn interest or dividends.
- Tax rates on unearned income are different than rates on earned income.
- Before retirement, unearned income can serve as a supplement to earned income; often it is the only source of income in postretirement years.
Understanding Unearned Income
Unearned income differs from earned income, which is income gained from employment, work, or through business activities. It cannot be used in contributions to individual retirement accounts (IRAs). According to the Internal Revenue Service (IRS), earned income includes wages, salaries, tips, and self-employment income.
Taxation will differ for earned income and unearned income due to qualitative differences. Additionally, tax rates vary among sources of unearned income. Most unearned income sources are not subject to payroll taxes, and none of it is subject to employment taxes, such as Social Security and Medicare. Therefore, it is crucial for individuals with unearned income to understand the origin and taxation of their income.
Types of Unearned Income
Interest and dividend income are the most common types of unearned income. Interest income, such as interest earned on checking and savings deposit accounts, loans, and certificates of deposit (CDs), is taxed as ordinary income.
Dividends, which are income from investments, can be taxed at ordinary tax rates or preferred long-term capital gains tax rates. Investments typically yield dividends payable to shareholders on a regular basis. Dividends may be paid to the investment account monthly, quarterly, annually, or semiannually. Each share receives a percentage of the company’s profit, which is known as the dividend yield. Taxation of the total sum of the dividend yield is at the current dividend tax rate. Money earned in this capacity is unearned income, and the tax paid is considered an unearned income tax.
Other sources of unearned income include:
- Retirement accounts—e.g., 401(k), pension, and annuity
- Lottery winnings
- Veteran's (VA) benefits
- Welfare benefits
- Property income
Unearned income is often a retiree’s only source of income.
Benefits of Unearned Income
Unearned income can serve as a supplement to earned income before retirement and is often the only source of income in postretirement years. During the accumulation phase, taxes are deferred for many sources of unearned income. Sources with deferment include 401(k) plans and annuity income. As a result, participants avoid IRS penalties and paying at higher tax rates. Tax advisors often recommend diversifying holdings to even out the effect of taxes on unearned income.
Examples of Unearned Income
Jan invests $50,000 in a CD. The interest she derives from her investment is considered unearned income. She also wins $10,000 in a game show, but she does not get the full amount of her winnings. Why? Because the IRS deducts taxes from it, treating the amount as unearned income.