Unearned Income
Unearned income is defined as income that is received from sources unrelated to employment, such as from investments. This includes, for example, interest paid to deposit account holders, dividends from securities, capital gain distributions.
Unearned Income explained
This type of income refers to money that a person or an organization receives from a job or working for oneself. First of all, it encompasses wages of employees, tips, bonuses, etc. A person cannot contribute to an IRA if he receives income only from an unearned source.
The tax rates on unearned and earned income differ. Besides, the tax tends to vary between different types. Most sources of income are exempt from payroll tax, and all of them by default are exempt from employment taxes. That’s why it's vital to know how the unearned income may be taxed.
Common types
Two of the most common are interest and dividend income. This money earned by financial assets or financial accounts is taxed at its own rates as it is defined as unearned income. This type of income received from savings accounts and certificates of deposit is taxable as ordinary income. But the interest on municipal bonds is exempt from federal taxes.
Dividends, the share of a company’s profit distributed among participants, employees, etc. (that is, shareholders) in proportion to the share of securities, most often shares, can be taxed at ordinary income tax rates or at preferential tax rates that are usually given to long-term capital gains. Dividends can be distributed quarterly, monthly, quarterly, annually, depending on the financial performance of the issuer.
Dividends can be divided into ordinary or qualified and it will influence taxation. The tax rates for ordinary dividends — payments passed on to the shareholders depending on the profit received by the business in the financial year — are the same as standard federal income tax rates. Unlike the first type of dividends, qualified dividends get taxed at more favorable rates.
Qualified dividends received from a foreign corporation or a company located in the U.S. must be held by an investor for at least 60 days out of a whole length of time a taxpayer holds it.
Other sources of unearned income are distributions from trusts, lottery winnings, forgiven debts, gifts, veteran’s benefits, individual retirement account and others.
Benefits of Unearned Income
Unearned income can be an additional source of income before a person retires, and may serve as the only source of income after he finishes working. During the period of life, in which an individual saves for retirement, there is a tax deferral for many types of unearned income.
401(k) plans and annuity income give a taxpayer an opportunity to delay paying the income tax levied by the government. Due to this, participants minimize failure to pay penalties and avoid paying a higher tax rate.
Example
Michael keeps $30,000 invested in a certificate of deposit. The interest rate that falls on the investment is defined as unearned income and it gets taxed at IRS-determined regular rates.
Besides, he hits the jackpot with a $20,000 prize. But lottery winnings are considered taxable unearned income and he does not receive the initial sum of money.
