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What is Unearned Income?

Unearned Income Definition

Unearned income is any form that does not come from wages, salary, or other earned sources. Unearned income can include investment gains such as interest, dividends, and capital gains; rental income; pensions; Social Security benefits; alimony; lottery winnings; and inheritance.

  1. In the eyes of the Internal Revenue Service (IRS), this income is subject to taxation, just like wages and salary. While unearned income is not subject to payroll taxes like Social Security and Medicare, it still must be reported on a taxpayer’s federal tax return.

The amount of unearned income that is taxable depends on the type of unearned income received.

What are the differences with earned income?

These two income concepts differ one from the other, and here’s why:

  1. Earned income is income derived from work, while unearned income is income that does not come from work. Earned income includes wages, salary, and tips. Unearned income includes investment gains, rental income, pensions, Social Security benefits, alimony, lottery winnings, and inheritance.
  1. Earned income is subject to payroll taxes like Social Security and Medicare, while unearned income is not. However, this income must still be reported on a taxpayer’s federal tax return. The amount of unearned income that is taxable depends on the type of unearned earning received.
  1. Earned income is generally taxed at a higher rate than unearned income. For example, in 2019 the highest tax rate for earned income is 37%, while the top tax rate for this type of income is just 20%. This difference in rates reflects the fact that earned income is considered to be more “precious” than unearned income by the government.

Types of Unearned Income Taxes

1. Investment income

Interest, dividends, and capital gains are the most common types of investment income. Investment income is unearned income because the money that is made from investments does not come from work. Instead, it comes from money that has already been earned and put into investments. This means that investment income is not subject to payroll taxes like Social Security and Medicare, but it is still taxable.

2. Rental income

This income is the income you earn from renting a property, such as apartments, houses, or land. The money made from the rent comes from the amount youโ€™ve acquired and put into the property.

3. Pension income

A pension plan receives income through regular payments or a lump sum distribution.

Pension income is unearned because the money paid out comes from money already earned and saved. Therefore, it’s taxable but not subject to payroll taxes

4. Social Security benefits

Benefits are paid to retirees and other eligible Americans by the Social Security Administration (SSA). These benefits are interpreted as this type of income because the money paid out comes from taxes that have been paid into the system by workers.

5. Alimony payments

These are payments made by one spouse to another following a divorce decree or separation agreement. Alimony payments are unearned income because the money that is paid out comes from money that has already been earned and saved.

6. Lottery winnings

These represent winnings from state-run lotteries and other gambling activities. These winnings come by change, making it a form of gambling income. Therefore, these are taxable, but they are not subject to payroll taxes like Social Security and Medicare.

7. Inheritance

Money or property received from a deceased relative or friend. Inheritance is unearned earning because the money or property that is received did not come from work. Instead, it comes from money or property that has already been earned and saved by the deceased person.

FAQs

Do you have to pay taxes on unearned income?

Yes. In most cases, the amount of taxable unearned income depends on the type of income received. For example, investment income is generally taxed higher than Social Security benefits. This difference reflects that investment income is considered “more precious” than Social Security benefits.

How much will you pay for this income?

Unearned income applies different tax rates. For example, the highest tax rate for earned income is 37%, while the top tax rate for this income is just 20%. This difference in rates reflects the fact that unearned income is considered to be less “precious” than earned income by the government.

This means that if you earn money from investments, rental properties, pensions, Social Security benefits, alimony payments, lottery winnings, or inheritance, you will pay less in taxes than if you earn that same money from a job. However, you must still report unearned income on your federal tax return.

How do you know if you have unearned income?

There are several ways. The most obvious way is to look at your pay stub and see if any of your income is unrelated to work. If it is, then you have unearned income.

Another way to determine if you have unearned income is to look at your tax return from the previous year. The unearned earning is generally taxable, but there are a few exceptions.

You can also contact the IRS or your tax preparer to determine what types of income are considered unearned. This information can be helpful when filing your tax return or answering questions about this type of income.

Next Steps

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