What is Unearned Income?

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Could unearned income be your golden ticket to winning on your taxes & financial wealth?

Lesson 2

Unearned income is the opposite of earned income. Unearned income is basically money you did not have break into a sweat to earn. You can think of it as passive income.

It also includes pensions, alimony, unemployment compensation, and other income that is not earned.

Unearned income examples

While the IRS website define earned income, it did not go into great details about unearned income but, did provide some examples. I also added additional examples to the list.

·         Pay received for work while an inmate in a penal institution

·         Interest (Bonds/Stocks), dividends & royalties

·         Retirement income

·         Social security

·         Unemployment benefits

·         Alimony

·         Child support

·         Pension

·         Alimony

·         Unemployment Compensation

·         Capital gains

·         Passive income generated from rental real estate

Unearned income can be define as all other income that are not generated or earned by performing labor or services. Ex: Jane Doe is employed at ABC Bank and earns a salary of $35,000 as Teller . Jane earned $250 in interest from certificate deposit (CD) she opened at the same bank where she works. Her salary of $35,000 is earned income because she has to show up and perform a service to earn the income. Her interest of $250 from the CD is unearned income, she did not have to work to make that money. This means Jane gross income is $35,250.

How does having unearned income affect your taxes?

The total gross income is considered for federal tax purposes. Hence, the unearned income gets added to the total gross in order to calculate the tax payers adjusted gross income (AGI). While earned income is subject to payroll taxes, unearned income is not. For the most part, unearned income is taxed at a marginal rate.  Here’s an FYI moment, certain types of unearned income, such as capital gains and qualified dividends are taxed at a much lower rate. There’s a great article on the Institute on Taxation and Economic Policy’s website, the title boldly reads: No Work Requirements for the Richest 1 Percent — Most of Their Tax Cuts Are for Unearned Income. In the article, Steve Wamhoff states “Most tax cuts enjoyed by the richest 1 percent of households under the recently enacted Tax Cuts and Job Act (TCJA) are tax cuts for unearned income.” What does the tell you? You need to get your money right, if you are not the CEO of managing your money, then it is managing you. The Wealthy will continue to be the 1% enjoying this tax benefit.

I recently completed a tax course which was very eye opening to say the least. Towards the end of the course we learned how to compute taxes for qualified dividends and capital gains distributions. I learned, Qualified dividends and capital gain distributions are treated as long-term capital gains, normally they are taxed at lower rates than regular (earned) income and short-term capital gains. 

According to the IRS website site…The tax rate on a net capital gain usually depends on income. The maximum tax rate on a net capital gain is 20 percent, but for most taxpayers a zero percent or 15 percent rate will apply. Furthermore, capital gains may be subject to the net investment income tax of 3.8 percent when income is above certain amounts (irs.gov).

Your Takeaway: I am not giving tax advice here (consult a tax pro). This is to get you curious and start thinking long term financial goals. The more you know, the more power and better equipped you’ll be in your decision making. This is what financial literacy is about. If you can start saving or are currently saving, save as much as you can, start as early as you can and start building multiple sources of unearned income, because this type of income is exempt from payroll taxes & therefore, you’ll pay way less taxes when tax time comes around. Also, if you think and move like the wealthy, you too can win at the money game.

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