Many people dream of living off passive income. The idea of working hard and creating a steady source of income is very appealing. Instead of working eight hours a day or more, you can work much less. Let’s say you are making some smart moves by investing in rental properties or dividend stocks.
Alternatively, you might get lucky and get a big inheritance or a big win at the casino. These sources of income are different from earning a normal salary at work from 9 to 5. The IRS considers these and some other sources of income to be unearned income. What is unearned income and how it differs from earned income. There is a definition of both as provided by the IRS.
What is unearned income?
Unearned income is income from sources, not from work or work. The IRS considers unearned income as income from sources other than personal effort. For example, income from wages, salaries, tips, self-employment and some other sources is earned income. However, a person must make an effort to obtain this income. Hence, blogging counts as earned income and not unearned income, although some bloggers might think it is passive income.
Income from most other sources is unearned income. This list includes investment income, dividend income, capital gains distribution, retirement benefits, social security benefits, unemployment compensation, child support, alimony, lottery winnings, gifts, inheritance, veteran payments, real estate income, fringe benefits, and others.
It is important to know the difference between earned and unearned income, as they are taxed differently in the United States. Earned income is subject to regular income tax and employment tax. Social Security and Medicare are types of employment taxes. On the other hand, unearned income is usually not subject to regular income tax, but is subject to capital gains tax. However, there are times when unearned income is taxed as regular income in the United States. Moreover, people do not pay employment tax on unearned income.
In addition, IRA contributions cannot be made from unearned income. Instead, the investor must use the earned income.
Examples of unearned income
Example A
The person receives $ 50,000 a year in wages as shown on the W-2 form. This same individual receives a $ 5,000 bonus, $ 2,000 in interest income on certificates of deposit or CDs, and a $ 2,000 qualified dividend. In this example, the $ 50,000 salary and the $ 5,000 bonus are earned income. $ 2,000 in interest and $ 2,000 in qualified dividends are unearned income. However, all sources of income in this example are taxed.
Example B
The retiree receives $ 37,776 a year in Social Security benefits and $ 14,400 a year in retirement benefits. The maximum benefit for reaching full retirement age is currently $ 3148 per month ($ 3148 x 12 = $ 37,776) in 2021. Both sources of income are considered unearned income.
Types of unearned income
The list below shows the most common types of unearned income. There are other types of course, but the ones on this list are common.
1. Investment income
Investment income is the profit from the sale of real estate or stocks. An investor who sells an asset for a profit will receive capital gains from the sale. Capital gains are treated as unearned income by the IRS. Investment income includes interest on savings, money market accounts, CDs, and bond dividends. Capital gains tax and interest income tax rates vary.
2. Distribution of long-term capital gains
Mutual funds pay shareholders a capital gains deduction. This money comes from the sale of stocks, bonds, or other assets owned by a mutual fund. The profit is distributed to shareholders in the form of capital gains. If the mutual fund is in a taxable account, shareholders must pay taxes on this unearned income. However, if capital gains are allocated to a tax-exempt account, taxes are deferred or not taxed depending on the type of account.
3. Dividend income
Dividend income is money paid to shareholders in the form of dividends paid by companies. The investor can earn passive income and possibly live off dividends. For tax purposes, dividend income is taxed differently depending on whether the dividend is ordinary or qualified. Ordinary dividends are taxed at the normal income tax rate, while qualified dividends are taxed at 0%, 15% or 20%.
4. Pension income
Retirement income is generated from pensions, annuities, and 401 (k) plans and 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 federal-as-needed payments.
There are differences between Roth and traditional IRAs for tax purposes. Traditional IRA contributions are made from pretax cash and are taxed upon withdrawal. Consequently, this type of IRA is tax deductible and the investor receives a tax deduction on deposit. Traditional IRAs require minimum allocations (RMDs). Roth IRA contributions are made in dollars after tax. In most cases, withdrawals are tax-free. Investors are not required to borrow RMD.
Social security benefits are another common type of retirement income. The program is designed to provide replacement income for retirees and their spouses. Workers contribute employment taxes to the program and receive a retirement benefit in the form of monthly payments upon reaching retirement age.
5. Unemployment benefits
Unemployment benefits are paid to people who have lost their jobs through no fault of their own. For example, an employee who loses his job as a result of a company-wide layoff will receive unemployment benefits. This unearned income is intended to partially reimburse the lost income of the employee due to his job search needs. If unemployment benefits come from federal or state funds, they are taxed as ordinary income.
6. Payment of alimony and child support
Both child support and child support are considered unearned income. However, alimony payments are in many cases taxed, while alimony payments are not deductible by the payer and the recipient is not taxed on income.
Alimony is the payment of a husband or wife to an ex-spouse. The term child support is also known as spousal support income. The amount and duration of payments are set in the separation or divorce agreement and awarded by the court. Alimony is paid to a spouse who has a lower income or no income.
The husband or wife pays child support to their ex-spouse who is in charge of the child. These are periodic payments to a child in case of separation or divorce, awarded by the court.
7. Winnings or prizes in the lottery
After buying a lottery ticket, the person who won the lottery is lucky, but winning is unearned income. Likewise, casino winnings, horse races, sports betting, off-piste betting and game shows are unearned income. This is due to the fact that the participant did not make any effort to receive money. However, you are required to report your income from the above sources. If the winnings exceed a certain dollar amount, the payer deducts 24% of federal taxes and provides an IRS Form W-G2.
However, if you are a professional player, the prize pool is the income earned. The IRS also distinguishes between gambling and skill games. For example, slot machines are considered a game of chance, while poker, blackjack, craps and roulette are considered a game of skill.
8. Gifts and inheritance.
Gifts are considered unearned income, but under certain circumstances are still subject to federal gift tax. From a tax point of view, gifts can be challenging, so it’s a good idea to ask a professional. Gift taxes are based on the dollar value of the gift, be it cash, property, stock, or other assets. Small cash gifts are not subject to gift tax. However, in 2021, the gift tax will be over $ 15,000 per person. A donor can donate up to $ 11.7 million in 2021 throughout their life without paying gift tax. Gifts to spouses and direct tuition fees are exempt. Consequently, few people actually pay gift tax.
The inheritance that a person receives after the death of a relative is unearned income. Inheritance is also difficult from a tax point of view and you should consult with a professional. Typically, there is no federal income tax on inherited cash, property, stock, or other assets. The exception, however, is that payments from legacy traditional IRAs are subject to regular income tax. On the other hand, Roth IRAs are funded with cash after taxes and are treated like other legacy assets. Another exception is that income from inherited rental properties or capital gains from investments sold are tax deductible.
9. Property rental income
Rental income is considered unearned income. However, income is still taxed. The main advantage is that rental costs can be deducted from income. Costs can include advertising, maintenance, insurance, taxes, utilities, supplies, repairs, etc.
Summary of what unearned income is
Unearned income is an interesting topic. Despite generating passive income, money, stocks, property, or assets may still be subject to federal taxes. In some cases, taxes must be paid in the current year. In other cases, taxes are paid at a certain threshold value or when the asset is sold. Taxes on unearned income can be more complex than taxes on earned income. Therefore, it may be worth exploring and planning adequate tax payment measures.
This post originally appeared on Savoteur.