It is easy to know about income from a paycheck or freelance work, but earnings can come from other places, too. Your tax liability is generally 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.
The last thing you need is the IRS knocking on your door because you didn’t know how to claim your unearned income on your return. There’s a chance you’ll owe on some of this money, but also a chance you might not, so it’s essential that you stay up to date on tax laws or take your documentation to a professional.
While most people are familiar with what earned income means, for some, the term 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. Anything you take home from your place of employment probably counts as earned income, although there are exceptions when it comes to certain bonuses. Examples of earned income include:
Your hourly rate at the job you work is part of your earned income. Your employer will probably automatically deduct money for taxes, making it far easier to keep track of what you’ve paid and how much you still owe.
A salary is similar to a wage except you earn a set amount per week, month, or year rather than an hourly wage. Your employer will probably deduct taxes from your annual salary, as well, streamlining the process for you.
Net Earnings From Self-Employment
Those who are self-employed have income and expenses, so doing their taxes is a little more challenging. You’ll have to track the money you have moving in and out to come up with your net earnings amount for the entire year.
Tips are a tricky one because they typically come in the form of a cash payment. There’s no way for the government to know how much you earn in tips in any given year, but they’re well aware that you have additional income if you work a job in the service industry. These payments count as earned income, so it’s best to be upfront about them.
Some self-employed individuals have very little in the way of expenses, so their self-employment income is a little more straightforward. Examples include small businesses that provide services without offering a product. The funds they earn through self-employment are earned income.
Nontaxable Combat Pay
Military personnel do not pay taxes on some of their income when they serve in a combat zone. This money is still earned income, but there are tax breaks available for these individuals.
Union Strike Benefits
Some unions will stockpile money to ensure members have the finances to hold out for a better long-term deal. These benefits are considered earned income, though, so union members should be prepared to pay taxes on them.
Long-Term Disability Benefits
Those with a long-term disability often rely on the benefits they receive. This money counts as earned income, which is an important distinction for these individuals to remember.
The IRS does not consider income from government benefit programs and investments as earned income. These earnings will instead fall into the unearned income category.
Unearned income refers to the income you receive from other sources unrelated to employment, such as passive investments 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 too.
Important note: You cannot use unearned income in contributions to individual retirement accounts. Also, unearned income sources are usually not subject to payroll taxes and employment taxes.
14 Typical Sources of Unearned Income
Accurately figuring out your tax situation depends on determining if you have unearned income that requires reporting. You don’t want to miss any of these sources because it could cost you in the long run. There are several sources of unearned income, but the most common include:
1. Investment Income
Investment income refers to the profit you earn from investments like real estate and stock sales. The dividends from bonds are also considered 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. The interest income also hopefully accumulates to produce investment income as your investment increases in value.
2. 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. It is worth noting, however, that the IRS taxes qualified dividends as capital gains as opposed to income.
3. 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.
4. 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.
5. Social Security Benefits
Social Security is a comprehensive U.S. 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.
6. 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. You should aim at getting back to work within the shortest time possible as you receive the benefits. Unemployment benefits are taxed as income if they come from a state or federal government fund.
7. 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.
8. Child Support Payments
Child 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 made directly or indirectly by the obligator or obligates, usually the noncustodial parent.
9. Lottery Winnings
Anyone who has ever purchased a lottery ticket has dreamed of someday hitting the right numbers and winning the grand prize. Those who are lucky enough to win a prize in a lottery will receive some unearned income in the process. You’ll need to be aware of how local taxation works, but by law, 24% of your earnings are withheld for federal taxes.
Someone giving you money out of the goodness of their heart sounds wonderful, but you should know that receiving cash or assets as a gift counts as unearned income. You’ll want to establish a tax strategy before receiving a financial gift, particularly if it’s for a substantial amount of money.
Any inheritance money you receive when a family member passes away is unearned income. You should develop a tax plan for dealing with this money because in some cases, such as when the inheritance arrives as assets rather than cash, you’ll only have to pay capital gains after you sell it.
12. Veteran’s Benefits
The Veterans Benefits Administration provides services like pensions, education, home loans, life insurance, health care, and disability compensation that could count as unearned income. It’s worth noting that veterans receive many benefits tax-free and that special tax refunds are available for disabled veterans. It’s a good idea for these individuals to seek professional tax planning assistance to ensure they aren’t overpaying on their unearned benefits.
13. Property Income
Owning a rental property can produce unearned income in many situations. The entire rental amount doesn’t fall into this category because you’ll use much of it to pay the rental home’s mortgage. You’ll have more unearned income once the mortgage is paid because you’ll pocket more of the rent money from your tenants.
14. Fringe Benefits
You could receive special benefits through your job that count as unearned income. These benefits might include reimbursement for things like childcare, mileage, and education. There’s a good chance these benefits will be taxable because they’re bonuses that fall under unearned income.
Other types of unearned income include some distributions from trusts, gambling winnings, forgiven debts, select forms of real estate income, and retirement accounts. 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. You will need to file a return, even if your earned income does not require it, should the total of your unearned income exceed $1,100 for a given year.
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 the details correctly.
Reach out to a wealth management professional for help if any of this leaves you confused. 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 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 supplement earned income before you retire, for example, and may serve as the only source of earnings after you’re finished working. That makes it important to diversify your holdings, maximize your earnings, and even out the effects of taxes on your unearned income.
Bogart Wealth can assist as you develop a financial plan that increases your unearned income, creating more financial security moving forward. We can also work with you to ensure your tax strategy minimizes your tax losses every year. Contact Bogart Wealth today to speak with an expert about any unearned income questions you might have.
Unearned Income FAQs
What is unearned income?
Unearned income is any type of income that is not generated from a job or business. Common examples include investments, Social Security, pensions, and rental property income.
How is unearned income taxed?
Unearned income is usually taxed at the same rate as earned income, however there can be certain deductions and exclusions that can reduce the amount of taxes owed.
What are some common types of unearned income?
Common types of unearned income include investment income, Social Security benefits, pensions, annuities, and rental property income.
Who is responsible for reporting unearned income?
Generally, it is the responsibility of the individual receiving unearned income to report it on their annual tax return.
Are there any exclusion or deduction rules that apply to unearned income?
Yes, certain exclusion and deduction rules apply to unearned income, such as 401(k) contributions, capital gains taxes, and tax-free interest income.
Is unearned income taxable in all states?
Yes, unearned income is generally taxable in all states according to the respective laws of each state.
Does unearned income count towards the threshold for filing taxes?
Yes, unearned income is included in gross income and must be reported on a tax return, even if the threshold for filing taxes is not met.
Does Social Security count as unearned income?
Yes, Social Security benefits are considered unearned income and must be reported on a tax return.
Is interest earned on savings accounts considered unearned income?
Yes, any interest earned on savings accounts is considered unearned income and must be reported on a tax return.
Is unemployment considered unearned income?
Yes, unemployment benefits are considered unearned income and must be reported on a tax return.