What is Unearned Income?

Posted by in Work & Income | Updated on August 26, 2022

No one would say no to extra money – especially if it’s passive income that requires no effort or time on your part. 

That is where Unearned Income comes in – a passive type of earnings that generally requires long-term investment and careful financial planning to yield big returns. 

It’s even more important to understand what is Unearned Income when it comes to your taxes as it can have various influences on your final tax bill compared to normal employment income. 

What is Unearned Income?

How do you make your income? For most people, it involves working either a 9-to-5 job, engaging in freelance work, or getting wages as a temporary worker. Basically, income comes from money received through personal effort. This money can be earned through a salary, wages, tips, or self-employment. It is also normally a person’s main source of earned income if they aren’t retired.

So what is Unearned income? Not all money earned is necessarily worked for and earned through a business. You could be supplementing your finances with income earned through interest on savings and dividends from stocks. This is called a passive source of income

Basically, if you receive any money you haven’t actively worked for it could be labeled as Unearned Income. If you’ve already retired, this kind of income might be your only source of finances you depend on. This income however can’t be used to make contributions to individual retirement accounts (IRAs). Contributions to IRAs instead have to come from your personal income you’ve worked for. 

Unearned income is usually taxed differently from earned income or business earnings. The tax also varies between types of Unearned Income. It’s ordinarily exempt from payroll and other employment taxes like Medicare and Social Security. On the other hand, Unearned Income could be subjected to Capital Gains Tax. Some of these types of income are also completely exempt from taxes – for instance when life insurance is paid out. 

When it comes to your own taxes, it’s vital to know where your Unearned Income comes from and how it might be taxed differently. 

Types of Unearned Income

Now that you understand what Unearned Income entails, how do you figure out which of your income streams falls under this category? If you haven’t invested time and effort into seeing a return on your personal effort, then that is more than likely your Unearned Income stream.

Here are some of the most common sources of Unearned Income:

  • Interest on savings and other positive accounts
  • Dividends on investments in the stock market
  • Inheritance from estates
  • Property income
  • Gifts
  • Retirement accounts (401k, pension, and annuity)
  • Lottery winnings
  • Unemployment benefits
  • Veteran’s benefits
  • Alimony.

The most common two streams of Unearned Income are interest and dividends. 

Interest income is generated by your bank accounts like savings, checking accounts, loans, and certificate of deposit. This kind of income is taxed the same as the normal income that you worked for.

Dividends, on the other hand, are earned through investment in the shares of public companies on the stock market. A company shares its profits with its shareholders as dividends on a monthly, quarterly, annually, or semiannually basis – depending on how much stock that shareholder owns. 

When it comes to tax, the dividend form of Unearned Income is taxed at ordinary dividend tax rates. But you can also opt to use long-term Capital Gains Tax rates instead. 

Capital Gains Tax rates are applied to investments that are sold that have grown throughout the years, including assets sold by companies. Capital Gains Tax won’t be applied to shares that appreciate every year. It only applies the day the shares are sold. Also, note the tax will be higher if the stock was held for less than a year. 

Benefits of Unearned Income

Besides the obviously appealing privilege of earning money you don’t have to work for, there are other benefits to Unearned Income. 

It boosts your total earnings when taken together with your earned income and could be a safety net during hard economic times or possible retrenchment. The current pandemic has especially been an eye-opener on the importance of having some passive income set up for rainy days.

For those who have retired or are no longer able to work, Unearned Income might be your only source of income. Unearned Income is best utilized if the income stream has been cultivated during your long working years. 

Taxes can also be postponed for some Unearned Income sources during their financial stockpile phase like retirement plans. In turn, this can reduce your total tax bill that will save you money in the long run. 

Unearned Income Examples

To help you understand what is Unearned Income, let’s look at a few examples.

Natalie puts a portion of her paycheck away into a savings account each month. It’s accumulated to quite a nice nest egg over the years, and she earns interest on it that helps grow her money. The interest Natalie earns would be considered Unearned Income. 

Ryan, on the other hand, buys a scratch card once a week when he goes to buy cigarettes. One day, he wins $1 million and is super chuffed with being a millionaire, until the IRS tells him he won’t get all of it due to taxes. His winnings are also considered Unearned Income. 

Claire rather invests her money in the stock exchange in stocks that are still priced quite low. She doesn’t sell when the price suddenly skyrockets and instead receives dividends quarterly when the company does well – this payout is her Unearned Income. 

Trevor was the main caregiver of his children when he was still married to his husband Chris. Chris was the main breadwinner. After their divorce, Trevor managed to secure alimony payments from Chris to maintain their children’s lifestyle. Trevor doesn’t work for these payments and thus they are considered Unearned Income. However, he can’t use this income to contribute to his own IRA and still works to ensure he’s comfortable when he retires.

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Regardless of where your income comes from, it remains vital that you declare all earnings to the IRS to avoid tax penalties. Understanding how your different income streams are taxed differently will help you file your taxes correctly and even reduce what you owe to the government. 

If you’re looking to put some money towards Unearned Income streams, many experts agree the key is to diversify your holdings so you don’t get any expensive surprises when you get your tax bill. This will also help lower your financial risk and maximize returns. 

Now the next time someone asks ‘what is Unearned Income’ at a get-together, you can use your new-found financial knowledge to wow and educate others. 

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