What Is Unearned Income?

What Is Unearned Income?

Let me explain unearned income directly: it's any income you earn passively, without doing work or providing a service. Unlike earned income from wages, salaries, or business activities, unearned income comes from investments or other sources where no labor is required. You'll see common examples like interest from savings accounts, dividends from stocks, and rental income from properties.

Key Takeaways

Understand this: unearned income is passive and not from work or business. It includes things like inheritance and interest or dividends from investments. Tax rates differ from those on earned income. Before retirement, it supplements earned income, but in retirement, it often becomes your main source.

Understanding Unearned Income

You earn unearned income through investments, such as interest on savings, dividends from stocks, or rent from properties. It's not tied to labor, unlike earned income from wages or self-employment. Remember, you can't contribute unearned income to IRAs—the IRS defines earned income as wages, salaries, tips, and self-employment earnings.

Taxation is different because of the qualitative differences. Tax rates vary among unearned sources. Most aren't subject to payroll taxes, and none face employment taxes like Social Security and Medicare.

Make sure you know the origin and taxation of your unearned income—it's important.

Types of Unearned Income

Unearned income falls into several categories, and I'll cover the main ones here.

Interest

Interest from savings accounts, bonds, loans, and CDs counts as unearned income. It's usually taxed as ordinary income, but there are exceptions like interest on municipal bonds, which is exempt from federal income tax.

Dividends

Dividends from investments can be taxed at ordinary rates or the lower long-term capital gains rates. These are paid regularly to shareholders—monthly, quarterly, annually, or semi-annually.

The taxation depends on whether they're ordinary or qualified. Ordinary dividends are taxed at ordinary rates. Qualified ones get capital gains rates if issued by a U.S. or qualified foreign corporation, held for at least 60 days in a 121-day period, and not excluded from qualification.

Other Sources of Unearned Income

You might also get unearned income from retirement accounts like 401(k)s, pensions, and annuities; inheritances; alimony; gifts; lottery winnings; Veterans Affairs benefits; Social Security benefits; welfare benefits; unemployment compensation; and property income.

Benefits of Unearned Income

Unearned income supplements earned income before retirement and often becomes the sole source after. During accumulation, taxes are deferred for many sources, like 401(k) plans and annuities, helping you avoid IRS penalties and higher rates.

Tax advisors recommend diversifying holdings to balance the tax effects on unearned income—consider that tip.

Examples of Unearned Income

Let me give you a couple of hypothetical examples to illustrate how this works.

Example 1

Suppose Jan invests $50,000 in a CD. The interest she earns is unearned income, reported to the IRS and taxed at ordinary rates. She also wins $10,000 on a game show, but doesn't get the full amount because the IRS treats it as unearned income and deducts taxes.

Example 2

Now, suppose Michael buys a property to rent out. He fixes it up into two apartments and leases them. The rent payments are unearned or passive income since he's not working to earn them.

What's the Difference Between Unearned Income and Earned Income?

Unearned income is passive, like interest, dividends, lottery winnings, or rental income. Earned income is compensation for services, from employers, self-employment, tips, bonuses, or vacation pay.

Do I Have to Pay Tax on Unearned Income?

Usually, yes. It's not subject to employment taxes like Social Security and Medicare, or most payroll taxes, but it's generally taxable—except for things like life insurance proceeds.

How Much Tax Will I Pay on Unearned Income?

It's not uniform. Some is taxed as ordinary income, some at lower rates, and with certain types, you can defer taxes.

What Is the Tax Treatment of Unearned Income for a Child?

Per the IRS, unearned income over $2,600 may face the kiddie tax. Alternatively, interest and dividends under $13,000 can be reported on the parent's return.

The Bottom Line

You might not be familiar with unearned income, but it's passive money without providing a service—simply, you don't work for it. Sources include interest, dividends, and rent. Report it on your taxes; check with the IRS, the issuer, or a tax professional if unsure about your liability.