What is Unearned Income?

According to the Internal Revenue Service and American Social Security Administration, unearned income is all the income which are not earned through an employment or business. These incomes are derived from means other than the provision of personal efforts. Unearned income includes interest and dividends, child support and alimony, rental income, prizes, lottery winning, etc.

How Does Unearned Income Work?

Unearned income is treated differently than earned income by the Internal Revenue Service for tax purposes. It recognizes the qualitative difference between the two types of incomes. The earned income includes salaries, wages, tips, and earnings from the business. Most common types of unearned income are interest and dividend income. Interest earned from checking and savings deposit account, certificate of deposit and loans are subject to taxation as ordinary income. Dividends earned from investment can be subject to ordinary taxation or preferred long-term capital gains tax rates can be applied to it. A share of a company's profit is paid to its shareholders as dividends. Dividends can be disbursed monthly, quarterly, annually or semi-annually. The total sum of the dividend yield is subjected to the current dividend tax rate. This tax is considered as unearned income tax. The other sources of unearned income include:

• Inheritance
• Annuities, pensions, workers' compensation
• Veteran benefits
• Gifts and contribution
• Prizes, lottery, settlement and awards
• Welfare benefits
• Child support and alimony payment
• Income from renting the property
• Cancellation of debt
• Taxable social security benefits
• Distributions of unearned income from a trust
• Insurance proceeds

The tax rates of the unearned income depend on the source of the income. Most of these sources are exempted from payroll taxes and none of the unearned income sources are subject to any employment taxes including Social Security and Medicare. Some unearned income like life insurance proceeds are not taxed at all. Individuals with unearned income need to know the taxation policy of the particular sources from where they derive that income. Unearned income sources are included in the calculation of Adjusted Gross Income (AGI) for federal income tax purposes. AGI can be found on line 37 of 1040 tax form. Unearned income supplements the earned income prior to retirement, and after retirement often this is the only source of income for many. One must remember that contribution to Individual Retirement Account cannot be made with unearned income. Among the unearned incomes, only the alimony counts as earned income for the sole purpose of IRA contributions. That means one can make a contribution towards the IRA with the alimony amount received. Emma earns $96,000 a year from her salary and $7,000 as a performance bonus. Additionally, she earns $10,000 as a dividend. So, Emmas earned income is $96,000+$7,000, and her dividend income is considered as unearned income or capital gains income. These two types of income will be taxed differently. Now, Emma has an Individual Retirement account and she leaves her job and remains unemployed for an entire year. As she will have to survive on her unearned income for the year, she will not be allowed to contribute to her IRA.