What Is Unearned Income and How Is It Taxed?

What Is Unearned Income?

The term unearned income refers to any income that is not acquired through work. Put simply, unearned income is any money you earn by doing nothing. This is in contrast to earned income, which is any compensation received for performing a service like work. There are many types of unearned or passive income, including interest from savings accounts, bond interest, alimony, and dividends from stocks.

Understanding Unearned Income

As noted above, unearned income is any money that is earned passively. It differs from earned income, which is any form of compensation gained from employment, work, or business activities. 

Unearned income cannot be contributed to individual retirement accounts (IRAs). According to the Internal Revenue Service (IRS), earned income includes wages, salaries, tips, and self-employment income. 

Taxation differs for unearned income and earned income due to qualitative differences. The tax rates also vary among unearned income sources. 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.

Types of Unearned Income

Interest

Interest and dividend income are the most common types of unearned income. Money received this way is unearned income, and the tax paid on it is considered an unearned income tax. Interest income is normally taxed as ordinary income on sources that earn income, including:

• Checking and savings deposit accounts
• Loans
• Certificates of deposit (CDs)

There are certain exceptions to this rule, including interest earned on municipal bonds, which is exempt from federal income tax.

Dividends

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 semi-annually.

Taxation of dividends is based on whether the dividend is ordinary or qualified:

• Ordinary dividends, the more common form of dividends 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. In order to qualify as qualified dividends, 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

You may get unearned income from other sources, such as:

• Retirement accounts like 401(k)s, pensions, and annuities
• Inheritances
• Alimony
• Gifts
• Lottery winnings
• Veterans Affairs (VA) benefits
• Social Security benefits
• Welfare benefits
• Unemployment compensation
• Property 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 higher tax rates. 

Examples of Unearned Income

Here are a couple of hypothetical examples to show how unearned income actually works.

Example 1

Let's say 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.

Example 2

Now let's suppose that Michael buys an investment property with the intention to rent it out for additional income. He fixes it up and converts it into two apartments: the main unit and the basement as a separate studio. He signs leases with two different tenants who pay their rent to Michael on the first of each month. The tenants' rent payments are considered unearned or passive income because Michael isn't doing any work to earn them.

The Bottom Line

Unearned income isn't a term with which most people are familiar. You may know it as passive income or money that you acquire without providing a service. Put simply, you make this money without actually working for it. Sources may include interest income from interest-paying accounts, dividends, and rent from tenants if you have an investment property. Just because it means it is earned passively doesn't mean you don't have to report it on your tax return. In fact, the opposite is true. Be sure to check with the IRS or the issuer of the unearned income, or you can consult a tax professional if you're unsure of what your unearned means to your tax liability.