The term unearned income refers to any income that is not acquired through work or active employment. Simply put, unearned income is money you earn by doing nothing. This contrasts with earned income, which includes any compensation received for performing a service, such as working a job. Various types of unearned or passive income include interest from savings accounts, bond interest, alimony, and dividends from stocks.
Key Takeaways
- Unearned income is not derived from employment or business activities.
- Examples include inheritance money, interest, and dividends earned from investments.
- Tax rates on unearned income differ from rates on earned income.
- Unearned income can supplement earned income before retirement and often becomes the primary source of income post-retirement.
- It is directly contrasted with earned income, which is compensation paid for performing a service.
Understanding Unearned Income
Unearned income encompasses any money 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 IRS guidelines, earned income includes wages, salaries, tips, and self-employment income.
Tax rates on unearned income vary due to the inherent differences between unearned and earned income. Most sources of unearned income are not subject to payroll taxes, and none are subject to employment taxes like Social Security and Medicare. Ensure you understand the origin and taxation of any unearned income you have.
Types of Unearned Income
Unearned income can fall into several categories. Here are the most common types along with their key considerations:
Interest
Interest and dividend income are the most common types of unearned income. Interest income, including income from checking and savings deposit accounts, loans, and certificates of deposit (CDs), is taxed as ordinary income. Exceptions include 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 more favorable long-term capital gains tax rates.
Types of Dividends
- Ordinary Dividends: Common and taxed at ordinary tax rates.
- Qualified Dividends: Have more favorable tax treatment and must meet certain criteria.
Other Sources
Unearned income can also come from other sources such as:
- Retirement accounts like 401(k)s, pensions, and annuities
- Inheritances
- Alimony
- Gifts
- Lottery winnings
- Veterans Affairs 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 is often the primary source of income during post-retirement years. During the accumulation phase, taxes on many sources of unearned income are deferred.
Tax advisors often recommend diversifying holdings to even out the impact of taxes on unearned income.
Examples of Unearned Income
Example 1
Jan invests $50,000 in a CD. The interest she derives from her investment is unearned income and must be reported for taxation at the ordinary income rate. She also wins $10,000 in a game show, but does not receive the total amount, as taxes are deducted by the IRS.
Example 2
Michael buys an investment property to rent out. The rental income paid monthly by tenants is considered unearned income because he isn’t actively working for it.
FAQs
What Are Some Types of Unearned Income?
Unearned income is income not derived from work. Examples include inheritance money, financial prizes, unemployment benefits, interest on a savings account, and stock dividends.
Do I Have to Pay Tax on Unearned Income?
Usually, yes. Unlike employment taxes, unearned income is generally taxable, although there are exceptions like life insurance proceeds.
How Much Tax Will I Pay on Unearned Income?
Taxation on unearned income varies. Some sources are taxed as ordinary income, while others may have preferential tax rates. There are also opportunities to defer taxes on certain types of unearned income.
What’s the Difference Between Unearned Income and Earned Income?
Unearned income is earned passively, like interest or dividends, whereas earned income is compensation received for providing a service or labor.
What Is the Tax Treatment of Unearned Income for a Child?
For 2023, unearned income above $2,500 for a child may be subject to a special tax called the kiddie tax. Alternatively, smaller amounts may be reported on the parent’s tax return.
The Bottom Line
Understanding and properly managing unearned income is crucial. Whether you’re earning interest, dividends, or rental income, it’s essential to know the tax implications. Ensure accurate reporting on your tax return to avoid issues. Consulting a tax professional can also help you navigate these complexities.
Related Terms: earned income, passive income, tax rates, investment income.
References
- Internal Revenue Service. “Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)”, Pages 6-7.
- Internal Revenue Service. “Publication 17, Your Federal Income Tax For Individuals”, Pages 44-74.
- Social Security Administration. “What Income Is Included in Your Social Security Record?”
- Internal Revenue Service. “Topic No. 403, Interest Received”.
- Internal Revenue Service. “Publication 550, Investment Income and Expenses”, Page 11.
- Internal Revenue Service. “Topic No. 404, Dividends”.
- Internal Revenue Service. “Publication 550, Investment Income and Expenses”, Page 19.
- Social Security Administration. “Social Security Handbook: 2136. What is Unearned Income?”
- Financial Industry Regulatory Authority. “Annuities: Overview”.
- Financial Industry Regulatory Authority. “Retirement Accounts: Types”.
- Internal Revenue Service. “Publication 525, Taxable and Nontaxable Income”, Page 36
- Internal Revenue Service. “Publication 17, Your Federal Income Tax For Individuals”, Pages 52-59, 65-74.
- Journal of Accountancy. “Understanding the New Kiddie Tax”.
- Internal Revenue Service. “26 CFR 601.602: Tax Forms and Instructions: Rev. Proc. 2022-38”, Page 8.
- Internal Revenue Service. “26 CFR 601.602: Tax Forms and Instructions: Rev. Proc. 2023-34”, Page 8.
