What Is Unearned Income?
Unearned income is income not acquired through work. Examples of unearned income, also known as passive income, include interest from savings accounts, bond interest, alimony, and dividends from stocks.
- Unearned income is not acquired through work or business activities.
- Examples of unearned income include inheritance money and interest or dividends earned from investments.
- Tax rates on unearned income are different from 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. Unearned income cannot be used to make 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. Money received this way is unearned income, and the tax paid is considered an unearned income tax.
Interest income, such as interest earned on checking and savings deposit accounts, loans, and certificates of deposit (CDs), is normally taxed as ordinary income. There are certain exceptions to this rule, including interest earned on municipal bonds, which is exempt from federal income tax.
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.
Taxation of dividends is based on whether the dividend is "ordinary" or "qualified." Ordinary dividends, the more common form of dividend that investors receive from a company, are taxed at ordinary tax rates. Qualified dividends, on the other hand, are taxed at the more favorable capital gains tax rates.
Qualified dividends must meet certain criteria. They must be issued by a U.S. corporation or qualified foreign corporation, the investor must own them for at least 60 days out of a 121-day holding period, and they cannot be in a category of dividends otherwise excluded from the qualified dividend classification.
Other sources of unearned income include:
- Retirement accounts—for example, 401(k)s, pensions, and annuities
- Lottery winnings
- Veterans Affairs (VA) benefits
- Social Security benefits
- Welfare benefits
- Unemployment compensation
- 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 it is often the only source of income in postretirement years. During the accumulation phase, taxes are deferred for many sources of unearned income.
Sources of unearned income that allow a deferment of income tax 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.
An Example of Unearned Income
Jan invests $50,000 in a CD. The interest she derives from her investment is considered unearned income and must be reported to the IRS for taxation at the ordinary income rate. She also wins $10,000 on 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.
What Are Some Types of Unearned Income?
Unearned income is income not earned from work. Examples include inheritance money, a financial prize, unemployment benefits, interest on a savings account, and stock dividends.
Do I Have to Pay Tax on Unearned Income?
Usually, yes. While not subject to employment taxes, such as Social Security and Medicare, and, in most cases, payroll taxes, unearned income is generally treated as taxable income—save for a few exceptions such as life insurance proceeds.
How Much Tax Will I Pay on Unearned Income?
Unearned income is not taxed uniformly. Some sources of unearned income are taxed as ordinary income, whereas others enjoy more generous tax rates. It's also possible with some types of unearned income to defer tax liabilities to a later date.