Learn how these differ and how they both can impact your budget.
What is unearned income?
Unearned income is personal income that is gained from sources unrelated to employment. For example, taxable interest, dividend income, unemployment benefits and alimony are considered unearned income.
Unearned income is a term used by the IRS to define income that is derived from means other than personal effort. The IRS considers wages, tips, salary and other taxable compensation to be earned income. Income that does not meet these criteria is considered unearned.
Knowing the difference between unearned income and earned income is important because the two are taxed differently.
While unearned income is frequently subject to taxes, it is typically not subject to payroll taxes. For example, earned interest is not subject to payroll taxes, but is frequently subject to a capital gains tax.
Unearned income also is not subject to employment taxes, like Social Security and Medicare taxes. Some unearned income, such as life insurance proceeds, are not taxed at all.
Other forms of unearned income that are less common include lottery winnings, gifts and money that is inherited, such as when an estate is settled.
IRA contributions cannot be made with unearned income. Instead, they can only be made with earned income.
Unearned income example
Jake’s income for the year was $80,000 from his salary, $5,000 in performance bonuses and $7,000 in dividend income. While the money from his salary and bonus are considered earned income, Jake’s dividend interest is not considered earned income, but rather capital gains income. Jake’s wages and bonus will be taxed differently than his dividend income.
When Jake retires, his retirement account and Social Security payments will supplement his income. This income will be considered unearned income, and will be treated as such.
Stephanie has an IRA and gets laid off from her job. She remains unemployed for an entire calendar year, living off unemployment benefits and earned interest from dividends. During this year, Stephanie is not permitted to contribute to her IRA because she has no earned income.
Did you make money on an investment this year? See if you owe capital gains tax.