Image Source: PexelsThe dream of dividend growth investing is to create a large enough passive income stream that a person does not need a regular job and salary. Real estate investors have a similar motivation. They want to generate rental income from their properties. The Internal Revenue Service (IRS) views these income sources differently than W-2 wages. They and other sources of money are considered unearned income.In this article, we will answer the question of what unearned income is, discuss how it differs from earned income, and summarize the various types.
What is Unearned Income? The Answer is Simple
The most straightforward definition is from the IRS. According to them, unearned income includes investment income such as taxable interest, ordinary dividends, and capital gain distributions. It also includes unemployment compensation, taxable Social Security benefits, pensions, annuities, debt cancellation, and trust distributions.Basically, it is income that is not earned from a job or a business. A person receives earnings without having to work for it. For instance, winning a lottery or an inheritance is unearned income.Most people will have earned and unearned income in their life. Most incoming cash flow in retirement will probably derive from unearned income sources.
What is the Difference Between Earned and Unearned Income?
Earned income is payment received in return for work or performing a service. It includes salaries, wages, tips, and self-employment income. Earned income is accepted in return for active labor. Unearned income is almost every other source of earnings.In addition, tax rate differences exist between unearned and earned income. The former is often taxed at a lower rate, which we view as advantageous. For instance, dividend tax rates for qualified dividends are lower than for ordinary income, irrespective of filing status or bracket. However, situations occur when unearned income is taxed at the same rate, such as for ordinary dividends.Another difference is that Individual Retirement Account (IRA) contributions cannot be made with unearned income; they must be made with earned income.
Examples of Unearned Income
Example A – Interest IncomeA person is paid a $100,000 yearly salary, as shown in a W-2 form. The same person receives a bonus of $10,000, interest income from a certificate of deposit of $5,000, and qualified dividends of $15,000. In this example, the $100,000 salary and the $10,000 bonus are earned income because they were received in exchange for providing work. The $5,000 in interest and $15,000 in qualified dividends are unearned income. However, all sources in this example are taxable but at different rates.Example B – Social Security and PensionA retiree receives $45,864 per year in Social Security Benefit and $16,400 per annum in pension payments. The benefit at the full retirement age is currently $3,822 per month ($3,822 x 12 = $45,864). Pensions and Social Security are considered unearned income by the IRS.
Types of Unearned Income
We now summarize the most common types of unearned income. Of course, there are other types, but these are the most common.
1. Interest Income
Interest is usually received from checking and savings accounts, money market accounts (MMAs), certificates of deposit (CDs), U.S. Treasury bills, and bonds. These sources, which are often short-term investments, are unearned income. They are generally taxed as ordinary income, with some exceptions. Municipal bond interest is exempt from federal income tax.
2. Capital Gains
A person selling investments, real estate, or another appreciating asset for a profit creates a capital gain, which is unearned income. For instance, selling rental real estate at a higher price than you paid is a capital gain. Similarly, selling equity at more than the cost basis creates a capital gain. They are taxed at the tax rate for capital gains instead of ordinary income.
3. Dividend Income
Dividend income results from distributions paid to shareholders from corporations. It is their share of profits. Dividends are also paid by mutual funds or exchange-traded funds (ETFs). An investor can generate passive income and potentially live off dividends in retirement, but it is unearned income. Dividend income is taxed by two methods depending on whether the dividends are qualified or ordinary. Ordinary dividends are taxed at the regular income rate, while qualified dividends are taxed at the 0%, 15%, or 20% capital gains rate, provided they meet specific requirements.
4. Retirement Income
Retirement income originates from pensions, annuities, and 401(k) IRA plan withdrawals. Social Security retirement benefits are part of this category. Additional types of retirement income are railroad retirement benefits, Department of Veterans Affairs pensions, and need-based payments from Federal funds.All these sources are unearned income. However, they are not all taxed the same. Pensions, Social Security, and traditional IRA withdrawals are taxed at the regular income rate. However, differences exist between Roth and Traditional IRAs. Traditional IRA contributions are funded with pre-tax dollars but are taxed when withdrawn. As a result, this type of IRA is tax-deferred, and a person gets a tax deduction when the contribution is made. Roth IRA contributions are funded with after-tax money. The withdrawals are tax-free in most cases.
5. Unemployment Benefits
Unemployment benefits are paid to people who lost their jobs through no fault of their own. For instance, a worker who lost their job resulting from companywide layoff would receive unemployment benefits. The payments are designed to partially replace a person’s lost income for necessities as they look for work. The payments are unearned income.If unemployment benefits are paid from state or federal funds, they are taxed as regular income.
6. Alimony Payments
Both alimony and child support payments are types of unearned income, but they are treated differently. Alimony payments are taxable, depending on the specifics. On the other hand, child support payments are neither deductible by the paying parent nor taxable income by the recipient.Alimony is a payment from a husband or wife to their former spouse. It is also known as spousal maintenance income. The amount and length of time are found in a separation or divorce agreement and granted by a court. Alimony payments are paid to the spouse who is earning less or has no income.A husband or wife pays child support to their former spouse who has child custody. These payments are periodic and awarded by a court to benefit the child during separation or divorce.
7. Lottery Winnings or Prizes
Winning the lottery is lucky, but the money is unearned income. Similarly, jackpots or winnings at a casino, sports betting, off-track betting, horse racing, and game shows are unearned income. The person did not work to earn the money. However, they are responsible for reporting their income from the aforesaid sources. If the winnings exceed a specific dollar value, the payer will subtract 24% for federal taxes and issue an IRS Form W-G2.That said, if you are a professional gambler, the money won is earned income because you worked for it. The IRS also views games of chance and skill differently. Slots are viewed as a game of chance, while poker, craps, blackjack, and roulette are considered a game of skill.
8. Gifts and Inheritance
Gifts are unearned income but are subject to federal gift taxes in certain situations. From the tax viewpoint, gifts can be a complex subject, and we recommend asking an expert. Taxes are based on the value of the gift, irrespective of whether it is cash, property, stocks, or other assets.However, in 2024, an annual gift tax exclusion of $18,000 per person applies. A benefactor can gift up to this amount without paying taxes. That said, a $13.61 million lifetime gift tax exemption exists in 2024. More rules exist, too. Gifts to spouses and dependents, medical expenses, and direct payment of tuition are exempt.An inheritance that a person receives after the relative’s death is unearned income. It is also complicated from a tax perspective, and we suggest consulting an expert. No federal income tax exists on inherited cash, property, stocks, or other assets. However, exceptions exist, so consult an expert.
9. Rental Property Income
Rental real estate income is unearned. However, it is taxable. The primary advantage is that expenses for rental real estate properties can be subtracted from the gross income. Expenses can include advertising, maintenance, licenses, insurance, taxes, utilities, supplies, repairs, etc.
The Bottom Line About Unearned Income
Many people do not understand the term unearned income. However, they will likely be affected by it, especially in retirement. The sources of this type vary but include interest, dividends, capital gains, pensions, 401(k) and IRA withdrawals, etc. Taxes are different for unearned versus ordinary income. In some instances, they are lower, which is a significant benefit. We recommend checking with a certified public accountant (CPA) or financial advisor to learn more.More By This Author:Automatic Data Processing Is OvervaluedStock Market This Week – Saturday, March 23UK High Yield Dividend Aristocrats 2024
