Unearned Income
Definition
Unearned income is income derived from investments, interest, dividends, and other sources not related to active work or employment.
Detailed Explanation
Unearned income includes money earned passively from sources other than wages, salaries, or self-employment. The IRS classifies unearned income separately from earned income because it is subject to different tax rules, such as capital gains taxes, dividend taxes, and the Net Investment Income Tax (NIIT).
Common types of unearned income include:
- Interest Income: Earnings from savings accounts, bonds, and certificates of deposit (CDs).
- Dividends: Payments from stocks or mutual funds, classified as either qualified (lower tax rates) or ordinary dividends.
- Capital Gains: Profits from selling assets like stocks, real estate, or collectibles.
- Rental Income: Income received from renting property.
- Social Security Benefits: May be partially taxable based on other income sources.
- Pension and Annuity Payments: Retirement income from employer-sponsored plans or personal annuities.
- Unemployment Benefits: Payments from government unemployment programs, which are taxable.
- Gifts and Inheritances: While generally not taxable to recipients, certain inherited assets may be subject to estate tax or capital gains tax upon sale.
Unlike earned income, unearned income is not subject to payroll taxes (Social Security and Medicare taxes). However, some high-income earners may owe the 3.8% Net Investment Income Tax (NIIT) on certain types of unearned income.
Example
Michael earns $50,000 in salary from his job but also receives:
- $2,000 in interest from his savings account
- $5,000 in dividends from stock investments
- $10,000 in capital gains from selling stocks
Michael’s total taxable income is $67,000 ($50,000 earned income + $17,000 unearned income). His earned income is taxed based on income tax brackets, while his capital gains and qualified dividends are taxed at lower capital gains rates.
Key Articles Related To Unearned Income
Related Terms
Capital Gains Tax: A tax on profits from the sale of investments or real estate.
Dividend Income: Payments received from stocks or mutual funds, classified as ordinary or qualified.
Estate Tax: A tax on the transfer of wealth from a deceased person’s estate.
Gift Tax: A tax imposed on large gifts exceeding the IRS exclusion limit.
Investment Income: Earnings from interest, dividends, and capital gains.
Net Investment Income Tax (NIIT): A 3.8% tax on investment income for high-income taxpayers.
Passive Income: Income earned with little to no active involvement, such as rental income.
Rental Income: Earnings from renting out property, subject to income tax.
Social Security Benefits: Government payments to retirees, some of which may be taxable.
Unemployment Compensation: Government payments to unemployed individuals, treated as taxable income.
FAQs
How is unearned income taxed?
It depends on the type — interest is taxed as ordinary income, capital gains have special tax rates, and some dividends qualify for lower rates.
Does unearned income affect Social Security benefits?
Yes, taxable unearned income can increase the portion of Social Security benefits subject to tax.
Do I have to pay payroll taxes on unearned income?
No, unearned income is not subject to Social Security or Medicare taxes, but some may owe the Net Investment Income Tax (NIIT).
Are capital gains considered unearned income?
Yes, capital gains from selling investments or property are a type of unearned income.
Can rental income be considered earned income?
No, rental income is classified as unearned income unless you qualify as a real estate professional under tax law.
Is unemployment income considered unearned?
Yes, unemployment benefits are unearned income and fully taxable.
Are gifts and inheritances taxable?
Gifts are not taxable to the recipient, but estates above federal limits may be subject to estate taxes, and inherited assets may incur capital gains tax upon sale.
Does unearned income count toward retirement contributions?
No, only earned income qualifies for IRA and 401k) contributions.
Do I need to pay estimated taxes on unearned income?
Yes, if you expect to owe $1,000 or more in taxes, you may need to make quarterly estimated payments.
How can I reduce taxes on unearned income?
Strategies include investing in tax-exempt municipal bonds, contributing to retirement accounts, and using capital gains tax-loss harvesting.
Editor: Colin Graves