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 stocks. Unearned income, also known as passive income, is income not acquired through work.
- Unearned income is not acquired through work or business activities.
- Instead, unearned income is derived from another source, such as an inheritance or passive investments that earn interest or dividends.
- 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 earned in this capacity 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 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 are the more common form of dividend that investors receive from a company. Ordinary dividends 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. 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.