What is Unearned Income?

Unearned income is like filling a swimming pool with rainwater instead of with a bucket…

If you’re trying to fill a swimming pool with water, a rainstorm can help you fill the pool faster. Rain will fall from the sky into the pool without you having to work to do it. This is like unearned income because money arrives in your account without you having to work for it. Money that you carry to the pool in a bucket is like earned income because you have to do work for it.

Unearned income is any income that an individual receives, but does not earn from working or employment.

Many people work at jobs or run businesses and receive a regular paycheck for their efforts. The money that a person receives in exchange for working is considered earned income.

However, people can receive income from many other sources. Investors may receive income in the form of dividends and interest payments. People can win a cash prize from a contest. Retirees can receive Social Security benefits or pension payments. All of these forms of income came from a source other than work, making them unearned income.

The differentiation between earned and unearned income is important for a few reasons. One of the main differences between earned and unearned income is how they are taxed. Most earned income is subject to payroll taxes (also known as FICA taxes), which help fund programs like Medicare and Social Security. These taxes are typically taken directly out of a worker’s paycheck.

Unearned income generally is not subject to FICA taxes, so the individual only pays income tax on unearned income. This means that unearned income is usually taxed at a lower effective rate than earned income.

The IRS also sets limits on some retirement account contributions based on earned income. For example, as of 2022, the typical contribution limit for an IRA is $6,000 or the individual’s earned income (increasing to $6,500 in 2023), whichever is less. If all of your income is unearned, then you can’t contribute to an IRA.

The primary difference between earned income and unearned income is how the person receives the income. People get earned income as compensation for their work or self-employment. They have to do something in exchange for that income.

Unearned income is money that someone receives from sources other than work. For example, an investor who receives a dividend did not have to work to get that dividend. They simply receive the payment because they own shares in a dividend-paying stock. Similarly, someone receiving a pension does not work to get pension payments. They get the payments without actively working for them (even if they had to work to qualify for the payments in the first place). If you do not have to actively work to receive a source of income, it counts as unearned income.

There are many different sources of unearned income. Some of the most common types are:

Interest is a common form of unearned income that many people receive. If you have a savings account that pays interest, you receive this type of unearned income.

When you put money in an account that pays interest, you receive regular payments from the bank that holds your money. The higher the interest rate and the higher your account balance, the more interest you receive.

You have to pay income taxes on interest, but because it is unearned, you don’t pay payroll or other taxes on it.

Investors who own shares in companies or mutual funds that pay dividends, receive distributions from those companies on a regular basis. The holders of the shares receive the payments because of their status as partial owners of the companies rather than as a result of work they do, which makes dividends count as unearned income.

In some cases (typically when an investor has held a share for an extended period) the IRS classifies dividends as qualified dividends, which makes them subject to a lower tax rate than the standard income tax rate.

If you owe money to someone, you typically get out of debt by paying the amount that you owe, plus interest. In some cases, creditors choose to forgive or cancel debts for people. This can happen if the debtor settles for less than they owe or for a variety of other reasons.

The IRS treats canceled debt as unearned income because it’s like receiving a payment in the amount of the canceled debt, then immediately using that payment to pay the debt. That means that you must pay income tax on the amount of debt that gets canceled.

If you appear on a game show or win some other contest, like a raffle, you might receive a cash prize. You receive income in the form of your winnings, but you didn’t make the money from work, which makes it unearned income.

Government benefits, such as unemployment or Social Security count as income and can be taxes, but are not related to work, which makes them unearned income.

Companies can also receive income from sources other than labor, such as from interest payments, but it’s not called unearned income. Generally, passive income for a business is reported in the ‘Other Income’ section of the income statement. It may be grouped together as other income or separated out as Investment Income, Interest Income, etc.

Companies also may report unearned revenue. However, this is different from unearned income, as it’s money received for work that has not yet happened but will take place in the future. It’s essentially prepaid revenue, such as a customer paying for goods or services that the company will deliver at a later date.

Because prepaid revenue requires that the company meet an obligation in the future to earn that revenue, it shows up as a liability on the balance sheet.

You calculate and pay taxes on your unearned income when you file your tax return each year. For the most part, unearned income is taxed at the regular income tax rate. However, because individuals do not receive it as part of a paycheck, it is not subject to payroll taxes, such as FICA tax. That means that the effective tax rate for unearned income is lower.

Some forms of unearned income, like qualified dividends and long-term capital gains, are taxed at a lower rate than normal income.

Generally, unearned income is taxed at the same tax rate as regular income, with the exception that you do not have to pay payroll taxes on your unearned income. This results in the overall tax rate for unearned income being lower than the tax rate for earned income that is subject to payroll taxes.

For 2022 and 2023, the income tax rates range from 10% to 37%.

Some forms of unearned income, such as qualified dividends and long-term capital gains are taxed at a lower rate.

Here are the long-term capital gains and qualified dividend tax rates for individuals with a taxable income: