It is easy to know about income from a paycheck or freelance work, but earnings can come from other places, too. Ideally, your tax liability is calculated based on your overall income, and it is imperative that you know all types of income and how the Internal Revenue Service (IRS) classifies them. This information becomes especially important during the tax season when all earnings must be included in your tax filing process.
While most people are familiar with what earned income means, for some, the term “unearned income” is ambiguous and confusing. Here’s what you need to know about unearned income and its tax implications.
Earned Income vs. Unearned Income
In a nutshell, earned income is any money earned from self employment or a job. Examples of earned income include:
- Net earnings from self-employment
- Self-employment income
- Nontaxable combat pay
- Union strike benefits
- Long term disability benefits
It’s important to note that the IRS does not consider income earned from government benefit programs and investments as earned income.
Unearned income, by comparison, refers to the income you receive from other sources unrelated to employment. It is derived from other sources such as passive investment that earn you interest and dividends. Earned income is usually subject to federal and state income taxes, but unearned income may or may not be. The tax rates on unearned income are different from those of earned income.
Important note: You cannot use unearned income in contributions to individual retirement accounts. Also, the unearned income sources are usually not subject to payroll taxes and employment taxes.
8 Typical Sources of Unearned Income
There are several sources of income unearned, but the most common include:
- Investment income
Investment income refers to the profit that you earn from investments like real estate and stock sales. Notably, the dividends from bonds are also considered as an investment income. Investment income may include dividends paid on stocks, capital gains derived from property sales, and interest earned on a savings or money market account. Ideally, as your investment increases in value, the interest incomes also accumulate to produce investment income.
- Dividend income
Dividend income is the money out of the profits of a company paid to the stockholders. Dividend income is typically considered income for a specific tax year rather than a capital gain. However, it is worth noting that the IRS taxes qualified dividends as capital gains as opposed to income.
- Long-term capital gains distributions
Capital gains distributions refer to the payment that you receive from a mutual fund. The income comes from an exchange-traded fund (ETF) as a portion of proceeds from the fund’s sales of stocks and assets. Should the fund gain profits from a sale of its stocks in a given year, capital gains are distributed to the shareholders.
- Retirement income
Retirement income includes annuities, cash earned from company pensions, and 401k plan or IRA account withdrawals. Retirement income can also include Social Security benefits and other benefits from annuities, profit-sharing plans, and insurance contracts. Your retirement income may be fully or partially taxable.
- Social Security benefits
In the U.S., Social Security is a comprehensive federal program designed to offer a form of replacement income for retirees and their spouses. Social Security benefits refer to the payments that are made to qualified retirees and disabled persons, or their spouses, children, and survivors after they pass away. There are also some special conditions where the program supports the children of the beneficiaries. Social Security benefits may be partially taxed.
- Unemployment compensation
Employment benefits are payments designed to offer you temporary income when you lose a job through no fault of yours. This income replaces lost earnings and helps you cover daily expenses as you look for alternative employment. As you receive the benefits, you should aim at getting back to work within the shortest time possible. Unemployment benefits are taxed as income if they are coming from a state or federal government fund.
- Alimony payments
Alimony payments refer to court awarded payments that your former spouse has to make to you within a separation or divorce agreement. These payments are designed to offer financial support to a spouse making lower or no income. The payment is also known as “spousal maintenance income,” and ensures a spouse lives the same quality of life they had when married. Alimony payments are taxable and should be included in your income.
- Child support payments
Chid support is also a court-ordered ongoing, periodic payment that a parent has to make for a child’s financial benefit following the end of a marriage or other relationship. The payment is paid directly or indirectly by the obligator or obligates, usually the non-custodial parent.
Other types of unearned income include some distributions from trusts, gambling and lottery winnings, forgiven debts, select forms of real estate income, retirement accounts, inheritances or gifts, lottery winnings, Veteran Administration (VA) benefits, welfare benefits, and property income. This list is not exhaustive, but it is an excellent place to start while determining whether your income is unearned income.
Tips for Filing Unearned Income
It’s important to understand that taxation varies for earned and unearned income owing to the qualitative differences. It is also vital to note that tax rates tend to vary among sources of unearned income. Notably, should the total of your unearned income exceed $1,100 for a given year, you will need to file a return even if your earned income does not require it.
Take into consideration the following tips when filing your taxes:
- Research and identify the names of the forms you need to file to claim the unearned income, e.g., Form 8615 (Unearned Income).
- Know your filing status early to determine the tax treatment
- Get the data right and avoid math errors.
- Double check your bank account information if you’re asking the IRS to direct deposit your refund.
- Don’t be late to file your returns and ensure you have captured all your details correctly.
Where there is confusion, reach out to a wealth management professional to help. The smallest mistake can lead to large issues with the IRS if you are not careful, and it’s nearly impossible for a non-expert to be certain they have done everything 100% correctly to claim their earned and unearned income on their tax forms. Be sure to work with a competent financial advisor to ensure you do not make any errors while filing your taxes.
Talk to the Experts About Managing Your Unearned Income
Unearned income offers several benefits. It can be supplementary to earned incomes before your retirement, for example, and may serve as the only source of earnings after you’re finished working. That makes it important to diversify your holdings to maximize your earnings and even out the effects of taxes on your unearned income.
Contact Bogart Wealth today to speak with an expert about any unearned income questions you might have.