If you’re one of the millions of people who file federal income taxes each year, there’s a good chance you’ve heard the term unearned income. You may even have some sources of unearned income, but do you know what this IRS term means?
What Is Unearned Income?
Unearned income is income from investments and other sources which is unrelated to employment. This includes income-type investments such as taxable interest, ordinary dividends and capital gain distributions.
Often referred to as passive income, unearned income is money you make with very little effort on your part. In other words, it’s money you receive without having to do work for it. The combination of employment income and sources of unearned income equal your gross income. When you retire, you will transition from living on earned income to relying on unearned income for your overall finances.
Unearned income is different from earned income, which includes all the taxable income and wages you get from working or from certain disability payments such as long-term disability benefits. The taxable income that qualifies as earned income includes wages, salaries, tips and net earnings from self-employment income.
What Is Unearned Income Tax?
Earning money while doing very little work is a good thing, right? Yes, but it’s not perfect. When it comes to federal income taxes, any unearned sources of income you have will be included in your AGI or Adjusted Growth Income. That’s because unearned income has to be reported, and it may even be taxed.
The tax rules for unearned income are different from the rules used to determine taxes on earned income. If you have sources of unearned income, you might want to consult a tax professional to determine which ones you will be required to pay taxes on. Some unearned income is not taxed at all, while others are taxed at different rates.
Since unearned income can be taxed at different rates and often lower rates, it’s in your best interest to do some research on the different sources of unearned income, and use that information when making decisions about investments.
Unearned Income Examples
If your income consists of more than just your paycheck, you may have sources of unearned income. The most common examples of unearned income are interest and dividends. But the list doesn't end there.
In addition to taxable interest, ordinary dividends and capital gain distribution, other examples of unearned income include pensions, unemployment compensation, taxable Social Security benefits, inheritances, alimony, rental real estate income, distribution from a trust or estate, cancellation of debt and annuity payments.