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What Is Unearned Income and How Does It Work?


Unearned income, also known as passive income, is derived from sources other than employment or business operations and can act as a financial safety net during times of job loss or financial crisis. It can also be a significant source of income during retirement. Unearned income is sometimes taxed differently than earned income. You might be able to use unearned income as a way to not just earn more during your retirement years but also as a tax planning strategy. For that, you may want to talk to a financial advisor.

How Unearned Income Works

Unearned income refers to the money you receive without engaging in active work or labor for it. It’s often generated when individuals invest their resources, such as money or property and receive a return without putting in additional work. For example, investing in the stock market can generate dividends, which is a form of unearned income.

Unearned income works on the principle of investing resources to receive a return without additional work. Let’s take the stock market for instance. When you invest in a company’s stocks, you become a shareholder. As a shareholder, you are entitled to a portion of the company’s profits, commonly known as dividends. These dividends, which you receive without actively working for the company, are a form of unearned income.

Another common form of unearned income is rental income. If you own a property and rent it out, the rent money you receive is considered unearned income. You’re not actively working each day to earn this income; instead, it’s your property that’s working for you.

Unearned income also includes interest from savings accounts or bonds. When you save money in a savings account or invest in bonds, the bank or the bond issuer pays you interest. This interest is another form of unearned income. Similarly, royalties from intellectual properties such as books, music, or patents, and gains from the sale of investments or real estate are also considered unearned income.

How Unearned Income Is Taxed

A couple calculating how much they will have to pay in taxes from unearned income.

When it comes to taxation, unearned income follows different rules than earned income. In the United States, the Internal Revenue Service taxes most unearned income at the regular income tax rate. But some types of unearned income, such as qualified dividends and long-term capital gains, are taxed at lower rates.

Understanding how specific forms of unearned income get taxed can be complicated, and impact your overall tax liability. Therefore, getting professional advice from a tax advisor or financial advisor to ensure that you’re making the most of your investments and minimizing your tax burden is recommended.

Types of Unearned Income

Unearned income can be categorized into various types, each with specific examples. Some of the most popular types of unearned income are:

  • Dividends: Money you receive from an investment that is paid out from corporate profits.
  • Rental income: If you own a property and rent it out through either long-term or short-term vacation rentals, it qualifies as unearned income.
  • Capital gains: When you sell an investment for more than you paid for it initially, you can have a capital gain.
  • Inheritance: Investments aren’t the only place you can receive unearned income. Receiving an inheritance would qualify as well.

These are just a few forms of unearned income that help in creating a diverse portfolio. However, you should keep in mind that each form comes with its own taxation rules and potential risks.

Benefits of Unearned Income

Unearned income offers various potential benefits. It allows individuals to earn money without actively working, providing an additional income source and can increase their financial security.

Moreover, unearned income could offer tax advantages, as some forms of it are taxed at lower rates than earned income.

Long-term capital gains, for example, get taxed at a maximum rate of 20%, whereas short-term gains could bump you up to a higher income tax bracket with a maximum rate of 37%.

Unearned income also plays an important role in wealth-building and retirement planning. It can provide a steady income stream, reduce dependency on active employment and even potentially help to enable early retirement.

The more unearned income you have, the less you may need to rely on employment to pay your bills.

Unearned Income vs. Earned Income

While earned income comes from active labor, and is generally stable and predictable, unearned income is often derived from investments that could be less predictable but potentially more lucrative.

Additionally, earned income comes with a higher tax rate and will take up more of your time actively working for it. But, by comparison, unearned income could offer you more flexibility and lower tax rates.

You should also note that unearned income can require initial resources and may carry the potential risk of loss. It’s important to either be experienced or have someone experienced in your corner, before making large investment choices that aim to secure unearned income.

Bottom Line

A couple researching the tax consequences for different types of unearned income.

Unearned income can offer potential financial security, additional money and even some possible tax benefits. However, you should understand the key differences between different types of unearned income and how it gets taxed.

Tips for Tax Planning

  • A financial advisor who is experienced in dealing with taxes related to a variety of investments and income sources could be an ideal partner to help maximize your tax planning strategies. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • You can use a tool, like SmartAsset’s free income tax calculator, to help you estimate what you might owe in taxes.

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