What is unearned income & how is it taxed? (with Examples)

What is unearned income?

Unearned income is a form of income that does not result from work or services performed. This income includes money that someone might receive as a gift, inheritance, alimony payments, rental payments, dividends from stocks and other investments, and different types of income that an individual did not physically perform labor to obtain.

Meanwhile, earned income is any form of wages you get due to direct labor or tradeoffs of your time (like working at a job).

You cannot attribute unearned income to individual retirement accounts (IRAs) because it does not stem from earned income. Unearned income is subject to taxation by the Internal Revenue Service, and you must report this accurately on tax returns by all individuals who secure such a type of income.

The tax rates for unearned income can vary according to the amount of money earned and the individual's filing status. Most income that is not attained through a salary or wages isn't liable for payroll taxes, and it also won't incur any employment tax obligations like Social Security and Medicare.

Knowing all sources of unearned income can help individuals save money on taxes and ensure they comply with federal laws surrounding such forms of compensation.

Types of unearned income

Interest

Interest is a type of unearned income generated when you lend your money to people or organizations. As someone who has lent out their money, whether in the form of bonds, stocks, or putting money into a savings account, you can receive a portion of that money back as passive income in the form of interest.

Dividends

Dividends are unearned income generated from investments, such as stocks. Companies will pay out dividends to their shareholders from their profits in the form of cash payments or additional shares.

Dividend investors seek to make money off of this type of passive income, and the IRS can levy tax on this as ordinary income, depending on the individual's tax rate.

The IRS may also levy tax as qualified dividends if the investor has held their stocks for at least 60 days out of the 121-day period that starts 60 days before the ex-dividend date.

Gifts

Gifts are another type of unearned income. When an individual receives a gift, he or she does not have to report any of it as taxable income.

However, there is a limit on the amount. For 2020 and 2021, individuals may receive up to $15,000 from a single giver without it being taxed. It rose to $16,000 in 2022.

Other Sources

Other sources of unearned income include:

• pension payments,
• alimony payments,
• lottery winnings,
• veteran affairs benefits,
• social security benefits,
• unemployment benefits,
• property income,
• welfare benefits.

Taxation of unearned income

Unearned income is exempt from Social Security and Medicare taxes, but it still affects your overall tax rate. It forms part of the calculation for Adjusted Gross Income (AGI), which takes into account all eligible deductions made above the line.

Knowing your Adjusted Gross Income (AGI) is vital to successfully completing your federal taxes, as it will determine both the amount you owe and if you qualify for deductions or credits. You can locate it on line 11 of 2022 Form 1040 when you file.

While most unearned income is subject to your marginal tax rate – the percentage of taxation that you pay within each top-tier bracket – some types, including capital gains and qualified dividends, are taxed at a reduced fee.

Benefits of unearned income

Savings

It's no secret that unearned income is a great way to pad your savings account. Whether it's coming from investments, allowances, or inheritance payments, unearned income can have a lasting effect on the amount of money you're able to put aside.

Financial security

One of the most significant advantages of having an unearned income is being able to securely and reliably maintain your financial stability.

This type of income, which can come from things like investments or social security, helps protect individuals from fluctuations in the economy, allowing them to manage their expenses more effectively over time.

With an income that doesn’t require hard labor for entry or upkeep, one can plan their financial resources with fewer worries and a greater sense of security.

Diversity in revenue stream

It's great to have a steady job that offers an earned income, but it may not always be enough to cover expenses.

That's why it can be beneficial to build a diversified income portfolio that includes unearned income too. It could help provide a sense of financial security and make sure that you're covered if unexpected costs arise or if anything changes with your earned income.

Improved net worth

Unearned income can be a great asset for improving your net worth, as it is not only consistent but also comes without the typical labor-related costs associated with wages. It is money made from sources that often require no exchange of goods or services and can include money from investments, dividends, or other passive sources.

As such, unearned income can prove to be a great way of taking control of your finances while simultaneously building a better future for yourself and those around you.

Examples of unearned income

Here are several examples of unearned income:

• Investment income, such as interest or dividends from stocks and bonds.
• Pension payments or Social Security benefits.
• Gambling winnings or lottery prizes.
• Alimony payments received from a former spouse.
• Gifts or inheritances.
• Property income, such as rent from real estate.
• Veterans affairs benefits or welfare payments.
• Unemployment benefits.
• Investment property income, such as royalties from real estate.
• Annuity payments.
• Child support payments received from a former spouse or partner.
• Gifts received from friends and family.
• Interest earned on savings accounts or certificates of deposit (CDs).

Conclusion

Remember to always seek professional advice from a reliable tax expert when filing taxes or making financial decisions. Doing so will help ensure that you understand any regulations associated with unearned income and ultimately make the best decisions for your financial future.