What Is Unearned Income?
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There are so many different types of income out there with different labels to separate them all. Sometimes it can be a little frustrating not knowing what a particular kind of income is, and what types are even available out there.
It is essential to fully understand the distinction between all the incomes available to you to make sure you don’t make any mistakes when filing your taxes, or especially if you are planning to have an Individual Retirement Account (IRA). As you only can use earned income to contribute to an IRA, it’s important to know what constitutes as both earned and unearned income.
Therefore, if you are looking to find the answer to what is unearned income, then you have come to the right place! In this article, we will provide a little background information on unearned income, earned income, and the differences between them. We will also give some examples of the various unearned income types to help you better understand them.
What is unearned income?
Unearned income is precisely as the name suggests – it’s a type of income that isn’t earned. This means the income will be entirely unrelated to employment. Popular examples of unearned income can be revenue coming from investments, and other areas which include interest from bank accounts, bond interests, dividends from stock, and alimony. Unearned income can also be known as a “passive source of income”, as it is not acquired through work.
Unearned Vs Earned income.
So what are the differences between unearned and earned income? Earned income is income which is gained from employment, work, and self-business activities. It is an income that has to be worked to attain. Earned income includes things such as salaries, wages, tips, bonuses, commissions, and self-employment income.
Unearned income is, therefore, the opposite as we briefly mentioned, as it is income that is derived from things like investments, and any interest and dividends. Taxation will, thus, differ for both earned income and unearned income due to the qualitative differences between them. As well as this, tax rates will vary among several sources of unearned income.
The majority of unearned income sources aren’t subject to payroll taxes, which are taxes that employers usually withhold from employee salaries and pay for them. They are also not subject to employment taxes such as Social Security and Medicare. This means it is vital for individuals to understand where their unearned income is coming from, and what the exact taxation of that income is.
Types of Unearned Income
We will now take a look at some of the most common types of unearned income, to give you a better idea of what is classed as unearned.
Interest is the charge of the privilege of borrowing money, generally expressed as an annual percentage rate, (APR). Examples of interest income can include money earned on a savings account, loans, and any banks where you hold a large deposit of money untouched for an extended period.
This interest is given to you for either borrowing or keeping money with the bank, or other financial avenues, and therefore is not an earned income.
The second most popular unearned income type is dividends. Dividends are income derived from investments. These are generally a portion of a company’s earnings or profits, which are distributed by the company to some of their shareholders. These dividends are managed by the company’s board of directors and can be issued either as cash payments, shares of stock, or other property. Cash dividends are the most popular way of receiving them.
These dividends can be paid to the investment account either monthly, quarterly or semi-annually. The taxation of the total sum of the dividend is at the current tax rate. This means money earned in this way is classed as unearned income, with any tax paid an unearned income tax.
Together with companies, there are also many mutual funds and exchange-traded funds which also pay a portion of dividends to their individual shareholders.
Inheritances are another form of unearned income. This is an income which has been given to someone by a deceased, or non-deceased family member, and therefore has not been worked to attain.
Income deriving from a property is another form of unearned income. Although this one might throw you a bit as you believe it is a type of earned income, it actually isn’t. Property income can include rent paid monthly by tenants in a building purchased by you or your family being rented over long periods. As well as being unearned income, this is also a favored avenue of passive income.
Retirement accounts are also another form of unearned income. The taxation of individual retirement accounts can vary according to the type of account, and depending on where you are living. If you are in the US for example, some states will tax all income, whether earned or unearned, while other states might exempt pension income from tax. If you do have some income from a pension, it is crucial to keep up to date with what your location’s rules are, and your taxes, in order to know if you owe any money.
Finally, when you sell a stock or financial asset to receive profit, this leaves you with a capital gain. The capital gain is considered a taxable income; however, it is also considered an unearned income. The taxation does vary on capital gains, depending on the length you held the asset before selling it. Therefore, it is important to calculate the amount of taxes you could potentially owe prior to selling the stock.
We hope this article has helped answer the question, “what is unearned income” and hopefully, now you will have a better idea of the various types of unearned income out there. One thing to remember the concept of unearned income easier, is anything that is unearned, is not earned under employment. This might help to know the difference in future!