Many people dream about living off passive income. The concept of working hard and creating a perpetual stream of income is appealing. Instead of working eight hours per day or more, you can work much less. Suppose you make some smart moves by investing in rental real estate or dividend stocks.
Alternatively, you can be lucky and receive a large inheritance or win big at a casino. These income sources are different from receiving a regular salary in a 9-to-5 job. The Internal Revenue Service (IRS) considers these sources of income and several others as unearned income. What is unearned income, and how does it differ from earned income. There is a definition of both as stipulated by the IRS.
What is Unearned Income?
Unearned income is income from sources, not from employment or a job. The IRS views unearned income as income from sources other than personal effort. For example, income from a salary, wages, tips, self-employment, and a few other sources are earned income. However, a person must put in the effort to make this income. Hence, blogging is considered earned income instead of unearned income, although some bloggers may think it is passive income.
Income from most other sources is unearned income. This list includes investment income, dividend income, capital gains distributions, retirement distributions, social security benefits, unemployment compensation, alimony, child support, lottery winnings, gifts, inheritances, veteran benefits, real estate income, fringe benefits, and others.
It is essential to know the difference between earned and unearned income since they are taxed differently in the US. Earned income is subject to regular income tax and employment taxes. Social Security and Medicare are types of employment taxes. On the other hand, unearned income is not usually subject to ordinary income tax but is subject to capital gains tax. However, there are instances when unearned income is taxed like regular income in the US. Moreover, people do not pay employment taxes on unearned income.
In addition, IRA contributions cannot be made with unearned income. Instead, an investor must use earned income.
Examples of Unearned Income
A person is paid $50,000 per year in salary, as shown in a W-2 form. The same person receives a bonus of $5,000, interest income from certificates of deposits or CDs of $2,000, and qualified dividends of $2,000. In this example, the $50,000 salary and the $5,000 bonus are earned income. The $2,000 in interest and $2,000 in qualified dividends is unearned income. However, all sources of income in this example are taxable.
A retiree receives $37,776 per year in Social Security Benefit and $14,400 annually in pension payments. The maximum benefit at full retirement age is currently $3,148 per month ($3,148 x 12 = $37,776) in 2021. Both sources of income are considered unearned income.
Types of Unearned Income
The list below contains the most common types of unearned income. Of course, there are other types, but the ones on this list are common.
1. Investment Income
Investment income is the profit generated from the sale of real estate or stocks. An investor selling an asset for profit will generate capital gains from the sale. The capital gains are considered as unearned income by the IRS. Investment income includes interest from savings, money market accounts, CDs, and dividends from bonds. The tax rates on capital gains and interest income may be different.
2. Long-Term Capital Gain Distributions
Mutual funds pay capital gains distributions to shareholders. This money comes from selling stocks, bonds, or other assets owned by the mutual fund. The profits are distributed to shareholders as capital gains. If the mutual fund is in a taxable account, the shareholders must pay taxes on this unearned income. However, if the capital gains distributions are in a tax-advantaged account, the taxes are deferred or grow tax-free depending on the type of account.
3. Dividend Income
Dividend income results from money paid to stockholders from the dividends paid by companies. An investor can generate passive income and possibly live off dividends. For tax purposes, dividend income is taxed differently depending on whether the dividends are ordinary or qualified. Ordinary dividends are subject to the regular income tax rate, while qualified dividends are taxed at 0%, 15%, or 20%.
4. Retirement Income
Retirement income is derived from pensions, annuities, and distributions from 401(k) plans and Individual Retirement Accounts (IRAs). Social Security retirement benefits are included in this category. Additional types of retirement income include railroad retirement benefits, Department of Veterans Affairs pensions, and payment from Federal funds based on need.
There are differences between Roth and Traditional IRAs for tax purposes. Traditional IRA contributions are made with pre-tax money and taxed when withdrawn. Hence, this type of IRA is tax-deferred, and the investor gets a tax deduction when the contribution is made. Traditional IRAs have required minimum distributions (RMDs). Roth IRA contributions are made with after-tax dollars. The withdrawals are tax-free in most cases. Investors are not required to take an RMD.
Social Security benefits are the other common type of retirement income. The program is designed to provide replacement income to retirees and their spouses. Workers pay employment taxes into the program and receive the retirement benefit as monthly payments at retirement age.
5. Unemployment Benefits
Unemployment benefits are paid to individuals who lose their jobs through no fault of their own. For example, a worker who lost his or her job as part of a companywide layoff would receive unemployment benefits. This unearned income is designed to partially replace a worker’s lost income for necessities as they look for work. If unemployment benefits come from federal or state funds, they are taxed as regular income.
6. Alimony and Child Support Payments
Both alimony and child support payments are considered unearned income. However, alimony payments are taxable in many instances, while child support payments are neither deductible by the payer nor taxable income by the recipient.
Alimony refers to payments from a husband or wife to their former spouse. The term alimony is also known as spousal maintenance income. The amount of the payments and duration are found in a separation or divorce agreement and awarded by a court. Alimony payments are made to the spouse that earns lower income or no income.
A husband or wife makes child support payments to their former spouse who has custody of a child. They are periodic payments made to benefit the child during separation or divorce and awarded by a court.
7. Lottery Winnings or Prizes
After purchasing a lottery ticket, a person who wins the lottery is lucky, but the winnings are unearned income. Similarly, winning at a casino, horse racing, sports betting, off-track betting, and game shows are unearned income. This fact is because the participant made no effort to gain the money. However, you are responsible for reporting your income from the above sources. If the winnings are beyond a specific dollar amount, the payer will deduct 24% for federal taxes and provide an IRS Form W-G2.
Though, if you are a professional gambler, the prize money is earned income. The IRS also differentiates between games of chance and games of skill. For example, slots are considered a game of chance, while poker, blackjack, craps, and roulette are considered a game of skill.
8. Gifts and Inheritance
Gifts are unearned income but are still subject to federal gift taxes in certain circumstances. From the tax perspective, gifts can be a complicated subject, and it is recommended to ask an expert. Gift taxes are based on the dollar value of the gift, whether it is cash, property, stocks, or other assets. Small gifts of money do not trigger the gift tax. However, the gift tax comes into play at more than $15,000 per person in 2021. A donor can gift up to $11.7 million in 2021 throughout their lifetime without paying the gift tax. Gifts to spouses and direct payment of tuition are exempt. Hence, few people actually pay the gift tax.
An inheritance that a person receives after the death of a relative is unearned income. Inheritance is also complicated from the tax perspective, and you should consult an expert. In general, there is no federal income tax on inherited cash, property, stocks, or other assets. However, the exception is that distributions from inherited Traditional IRAs are subject to regular income tax. On the other hand, Roth IRAs are funded with after-tax money and treated like other inherited assets. Another exemption is that income from inherited rental property or capital gains from sold investments are taxable.
9. Rental Property Income
Income derived from rental real estate is unearned income. However, the income is still taxable. The main advantage is that expenses for rental properties can be subtracted from the income. Expenses can include advertising, maintenance, insurance, taxes, utilities, supplies, repairs, etc.
Summary on What is Unearned Income
Unearned income is an involved topic. Despite receiving income from a passive activity, the money, stock, property, or asset can still be subject to federal taxes. In some cases, the taxes must be paid in the current year. In other cases, taxes are paid at a particular threshold value or upon sale of the asset. Taxes for unearned income may be more challenging than dealing with taxes from earned income. Therefore, it may be worthwhile to research and plan to adequately deal with the taxes.
Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor and blogger on dividend growth stocks and financial independence. Some of his writings can be found on Seeking Alpha, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, Entrepreneur, FXMag, and leading financial blogs. He also works as a part-time freelance equity analyst with a leading newsletter on dividend stocks. He was recently in the top 1.2% (98 out of over 8,252) of financial bloggers as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.