The IRS has defined two specific types of income: earned and unearned. Understanding the differences between the two is necessary for paying federal and state income taxes. You'll also need to know whether your income is earned or unearned if you wish to take advantage of certain tax-deferred investments.
Getting paid for what you do is unquestionably a good thing, but getting paid for things that don't involve getting out of bed and going to work might be even better. That's the fundamental difference between earned and unearned income: If you've worked for it, it's probably earned income, and if it's money that rolls in no matter what you do, it's unearned income. If you suspect that the IRS' definition of unearned income is a bit more complicated than that, you'd be right.
What Is Unearned Income?
The first test for whether an income is earned or unearned is to look at the definition of earned income and see if it applies. The IRS considers your income to be earned if it's in the form of wages, salaries, tips and other taxable pay; union strike benefits; disability payments you receive before you've reached retirement age and earnings from operating your own business. There are a few other special cases as well, but those are the important ones. Unearned income, then, is defined as income that doesn't come from things. Some specific examples listed in Publication 17 include taxable interest, capital gains, dividends and distributions of capital gains, unemployment payments if you're laid off and various forms of scholarship or retirement income.
Why Is it Unearned?
Most of these forms of income are considered to be unearned, but they're unearned for a reason. Those reasons vary. For example, if you have scholarship income, you may have "earned" it through years of hard slogging at school, but not by working for wages in the conventional sense. Pension income is a by-product of your former employment income, which means you're benefiting from work income you've already paid taxes on. In much the same way, money you've sent out to work for you – whether by earning interest or as an investment in funds or individual equities – may originally have come from your wages or salary, but you've already paid your taxes on that.
Why Investment Income Has Lower Taxes
One thing you'll notice about unearned income is that a lot of it is investment income. If you buy CDs, for example, or have money in a savings account, the interest from those is considered to be unearned income. Capital gains from the growth of an investment count as unearned income. If your capital gains came indirectly when a fund you own took a profit on one of its holdings, your share of that – a capital gains distribution – is also unearned income. If you have an income portfolio built of stocks that pay dividends, the dividend payments you receive are also considered to be unearned income. Interest income is taxed like your regular earned income, while dividends and capital gains attract less tax. There are reasons for investment income to receive favorable tax treatment. A cynic might argue that tax law favors the affluent. A more balanced view is simply that economic growth requires active investment rather than passive interest-earning, so the tax system is structured to provide incentives to invest.
What the Rates Are
The tax rates you pay on your ordinary income, which is to say earned income plus interest income, vary pretty widely. They depend on your status – single, married filing jointly or separately, head of household and so on – and how much you've earned during the year. At lower incomes, you could pay as little as 10 or 15 percent, but at the time of this writing, incomes of $37,950 and up, per person, could attract taxes of 25 percent to 39.6 percent. By contrast, dividend income and long-term capital gains go untaxed if you're in the lower two income brackets. If you're in one of the brackets ranging from 25 to 35 percent tax on your ordinary income, you'll pay 15 percent on these forms of investment income. If you're in the highest bracket, at 39.6 percent tax on your ordinary income, you'll pay 20 percent on dividends and capital gains. That's approximately half the rate you'll pay on your ordinary income.
That favorable treatment of investment income is great, but you're still paying taxes on the growth of your money. If you're trying to build a nest egg for retirement, you can take things a step farther by holding your investments in a tax-sheltered account, such as an IRA or an employer-sponsored 401(k). In those accounts, your money can grow without taxation until you retire, which is a huge advantage. With a standard IRA or a 401(k), you make your contributions with pre-tax dollars and pay tax on the money when you take it out in retirement. Presumably, your income then will be lower, so you'll pay less on it by then. Putting money into the plan also reduces your taxable income for the year, which is another useful benefit. Roth IRAs work the opposite way. You pay into them with after-tax dollars and don't get to deduct your contributions from your taxable income, but they give you tax-free income after you retire. You can also take your contributions out of a Roth IRA without taking a tax hit, so it's also a potential source of emergency funds.
What About the Kids?
Another time-honored way to pay even less tax on your unearned income is to put some of it in your kids' names. Unless you're parenting a child star, their income is probably lower than yours, and they'll be in one of the very lowest tax brackets. In the hands of a dependent child, interest income can attract little or no tax, and the taxes on dividend or capital gains income will typically be zero for most kids, especially when they're young. You'll find a brief discussion of children's unearned income in IRS Publication 17, in the chapter on figuring your taxes, but for a fuller explanation, you'll need to turn to IRS publication 929. That's the one that deals with tax rules for children and other dependents, and with that in hand, you'll be able to decide fairly quickly whether you'll gain an advantage on your own taxes.
UTMA and UGMA Accounts
You'll need to set up some form of arm's-length account, or custodial account, to legally transfer investments – and the unearned income they generate – to kids. There are education-specific accounts, but they have a lot of restrictions built in. A more flexible approach is to use a Universal Transfer to Minors account, or UTMA, for the purpose. Some states have a slightly different version called a Universal Gift to Minors account, or UGMA, but they're pretty similar in how they work. You set up the account with a custodian, either yourself or another responsible adult, who manages the account and its investments on the child's behalf. This strategy reduces your taxable income and puts a nest egg into the hands of your kids, both of which are excellent things, and unsurprisingly a lot of parents in the past really abused the opportunity. The UTMA tax rules the IRS has in place as of 2018 only allow the first $2,100 of a child's unearned income to go untaxed. Above that, it's taxed at the same rate as traditional trusts and estates.
A Few Downsides of UTMAs
Nothing is perfect, of course, and there are some definite drawbacks to creating a UTMA for your kids. One is that you've just handed over those investments and they're no longer yours. If you're the custodian, you can legitimately spend some of that money on the child's expenses, but you can't take it back for your own use. Even more importantly, those investments and the income they generate become your child's property at the age of majority with no limits on how they're used. There are a couple of really obvious problems with that. One is that it can affect your child's eligibility for student loans, which can be a complication even if you had always intended the account to be a college fund. Another is that young adults aren't always good money managers, and there's nothing to say your 20 years of saving won't get chewed up in a bout of heavy-duty partying. All you can do is train your kids well in the use of their money and hope that they're goal-oriented enough to use it wisely. Fortuitously, getting them involved in the details of their own UTMA can be a good way to help them grow up to be fiscally responsible.
- U.S. Internal Revenue Service: What Is Earned Income?
- U.S. Internal Revenue Service: Publication 17, Your Federal Income Tax
- The Motley Fool: Your 2018 Guide to Dividend Taxes
- The Motley Fool: Long-Term Capital Gains Tax Rates in 2018
- The Motley Fool: How Does an IRA Work?
- The Motley Fool: What Is a 401(k)?
- U.S. Internal Revenue Service: Publication 929, Tax Rules for Children and Dependents
- Oppenheimer Funds: UGMA/UTMA Accounts
- Fidelity Investments: Kids and Taxes - Answers to 6 Top Questions