Unearned Income Definition
Unearned is the personal income earned by the person from the sources which are not related to employment. It is the term which the IRS uses for defining the income which is derived from the means other than the personal effort of the person. The taxation of unearned income is different from that of the earned income due to the qualitative differences.
Also, the tax rates may vary among the different sources of the unearned income. Most of these incomes are not subject to payroll taxes and employment taxes. Thus, it is important for individuals who have such income to have an understanding of the origin of the source of income and its taxation impact.
Top 4 Types of Unearned Income
#1 – Interest Income
Interest income is the income which is earned by investors on the investment made by him over the period of time. Examples of the interest income can be the income earned from the savings deposit accounts, certificates of deposits, loans, etc.
#2 – Dividends
The dividend is the income earned from the investments that may be taxed at the ordinary rate of taxation or the rate of tax on the long term capital gains. Dividend income is received from the investments in the company which gives the dividend to its shareholders. Each of the shares in the company receives a percentage of the company’s profit.
#3 – Rental Income
Rental income is the income which is earned by a person when he rents out his property to the other person. The other person pays the amount to the owner of the property for using the owner’s assets. This income is derived from the means other than the personal effort of the person so it will be treated as the unearned income.
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#4 – Gifts and Contributions
Gifts and contributions are the amounts received in cash or kind by a person from the other person. In the case of gifts and contribution income is earned by the person from the sources which are not related to the employment so it will be treated as the unearned income.
There are other types of unearned income as well which include, annuities, prizes, lottery winnings, Proceeds of insurance policies, alimony payments, Welfare benefits, Inheritances, Retirement accounts, etc. In all such cases income is earned by the person from the sources which are not related to the employment and do not require the personal efforts, so they will be treated as the unearned income.
Unearned Income Example
Jill is working in a manufacturing company as the manager of the company. During the month he earned a salary of $65,000 and a performance bonus of $9,000 from the company. Apart from the above income he also earned $5,000 as a dividend income and $10,000 as the interest income during the same month. The income earned by Jill from the sources which are related to the employee will be considered as the earned income and the income earned from the sources which are not related to the employee will be considered as the unearned income.
In the present case salary and performance, the bonus is employment-related earning which included the personal effort so it will be treated as the earned income and the income from dividend and interest are not related with the employment and also does not include personal effort so it will be considered as the unearned income.
Therefore calculation of earned income using below formula is as follows,
Earned Income = Salary + Performance Bonus
- Earned income = $65,000 + $9,000
- = $74,000
Therefore calculation of unearned income using below formula is as follows,
Unearned Income = Dividend Income + Interest Income
- = $5,000 + $10,000
- = $15,000
Jill’s salary and bonus income will be taxed in a different manner than his income from dividend and interest.
Advantages of Unearned Income
- After retirement, it is the only source of income.
- Unearned income from many of the sources helps in deferring the taxes and avoiding the penalties of the IRS.
- It requires little continues effort in order to maintain it. Often the initial effort of the considerable amount is required in order to create the source of unearned income, but once created after the initial efforts, it gives income over the period of time with the little or no amount of additional efforts.
- In the case of this income, future income from the same source is not guaranteed. So if the person is earning the unearned income today from one source than is not sure that he will earn it from the same source in the future as well.
- In the initial period of creating the source of unearned income, additional efforts and the investments are required and payment received against such efforts is also not immediate.
- This income is not typically subject to the payroll taxes, employment taxes
- In the initial period of creating the source of unearned income, additional efforts and the investments are required and payment received against such efforts is also not immediate. But once the source of additional income is created after the initial efforts, unearned income from many sources give income over the period of time with the little or no amount of additional efforts
- There may be different tax rates for the income earned from different sources.
The unearned income is the income received from the investments or the other sources which are not related to employment. The different examples of the unearned income include interest received from the investment, dividends, royalties, pension funds. In all the mentioned examples, the income is not derived from the means that require the personal effort of the person, so they are categorized as the unearned income.
Unearned income from many of the sources helps in deferring the taxes and avoiding the penalties of the IRS. There may be different tax rates for the income earned from different sources. It is preferable to diversify the holdings to even out the effect of the taxes that are applicable.
This has been a guide to what is Unearned Income and its definition. Here we discuss the types of Unearned Income along with examples, advantages, and limitations. You can learn more about finance from the following articles –