Unearned income, also known as passive income, is earnings generated from sources that do not need active labor or services. It differs from earned income, which originates primarily from wages, salaries, and business activities. Unearned income commonly comes from dividends on stocks, interest from savings accounts, and rental income from properties.
While earned income such as wages and self-employment earnings are directly tied to labor, unearned income primarily comes from investments, and does not require active work. However, unlike earned income, unearned income cannot be contributed to individual retirement accounts (IRAs).
There are significant differences in how unearned and earned income are taxed due to their qualitative differences. The tax rates differ among unearned income sources, with most sources not subject to payroll taxes. In addition, none of these income types are subject to employment taxes such as Social Security and Medicare.
Common types of unearned income include interest income from savings accounts, bonds, loans, and certificates of deposit; dividends from investments; and rental income from properties. In some cases such as interest from municipal bonds, tax exemptions exist. Dividends, which categorizes as income from investments, may be taxed at ordinary tax rates or preferred long-term capital gains tax rates.
Unearned income can contribute significantly to income before retirement and often becomes the sole income source during post-retirement years. During the accumulation phase, taxes on many unearned income sources are deferred. In particular, income from sources like 401(k) plans and annuity income allows for tax deferment.
For instance, if an individual invests a certain amount in a CD, the interest accrued is classified as unearned income and reported to the IRS for taxation at the ordinary income rate. If an individual purchases an investment property with the purpose to rent it out, the rental income generated is also considered as unearned income since no active work is performed to earn it.
In conclusion, unearned income is any form of income generated passively, such as interest on investments, dividends, and rental income from properties. Despite being exempt from social security and Medicare taxes, unearned income is typically treated as taxable income. It's key to understand the tax implications of unearned income and consult tax professionals if necessary.