Many people dream of living off passive income, such as investing in rental properties or dividend stocks. If you are lucky, you may inherit enormous wealth.
And in a report Published by the American investedwallet, writer Prakash says that sources of passive income differ from the source of fixed income that you receive from working in a full-time job.
Revenue from this type of income source is considered unearned income.
What is unearned income? How is it different from earned income?
Unearned income
It is income derived from sources unrelated to work or personal effort. On the other hand, salary, tips, self-employment and some other sources are considered earned income. Making money blogging is also considered an earned income, although some bloggers may think of it as passive income.
The list of sources of unearned income includes investing, dividends, capital gains distributions, retirement distributions, Social Security benefits, unemployment compensation, alimony, child support, lottery winnings, gifts, inheritances, veterans’ benefits, real estate income, fringe benefits and more.
It is necessary to know the difference between earned and unearned income because they are taxed differently in many countries.
Income earned is subject to ordinary income tax and employment taxes, such as Social Security and Medicare.
Unearned income is not subject to ordinary income tax, but to capital gains tax. And people don’t pay employment taxes on unearned income.
Examples of unearned income
Example A: In the case of someone who earns a salary of $50,000 annually, and then receives a bonus of $5,000, interest income from certificates of deposit of $2,000, and qualified dividends of $2,000, the salary and bonus are considered earned income, while interest and qualifying dividends are unearned income . But all sources of income in this example are taxable.
Example B: A retiree receives $37,000 per year in Social Security benefits, and $14,000 per year in pension payments, with the maximum benefit at full retirement age being $3,000 per month in 2021. In this case, both sources represent unearned income.
Types of unearned income
The list below represents the most common types of unearned income:
1. Investment income
Investment income represents the revenue generated from the sale of real estate or stocks. An investor who sells an asset for a profit is making a capital gain. To the IRS, capital gains are considered unearned income. Investment income includes interest from savings and money market accounts, certificates of deposit, and bond dividends. The tax rates on capital gains and interest income are different.
2. Long-term capital dividends
Mutual funds pay capital dividends to shareholders. This money comes from the sale of stocks, bonds, or other assets owned by the mutual fund. Profits are distributed to shareholders as capital gains. If the mutual fund falls under a taxable account, the shareholders must pay taxes on this unearned income.
3. Dividends
Dividend income is generated from the money paid out to shareholders from dividends paid by companies. An investor can generate passive income and may live off dividends. In terms of taxation, it depends on whether the dividend is ordinary or qualified. Ordinary dividends are subject to the ordinary income tax rate, while qualified stock dividends are subject to tax at 0%, 15% or 20%.
4. Retirement income
Retirement income is derived from pensions, annuities, distributions from retirement plans, and individual retirement accounts. Social Security retirement benefits fall into this category.
Traditional financial IRA contributions are paid without any taxes withheld, and taxes are levied when withdrawn, i.e. this type of IRA is tax-deferred, and the investor receives a tax deduction when making the contribution.
5. Unemployment benefits
Unemployment benefits are paid to individuals who have lost their jobs against their will. For example, a worker who lost his job during mass layoffs receives unemployment benefits. This unearned income is designed to partially replace the lost income of the worker in order to provide for necessities while he is looking for another job.
6. Gifts and inheritance
Gifts are considered unearned income but are still subject to gift taxes in certain circumstances. From a tax perspective, gifts are a complex subject, so it is advisable to consult an expert. Gift taxes depend on the value of the gift, whether it is cash, property, stocks, or other assets. In contrast, small cash gifts are not subject to the gift tax.
Gifts to spouses and direct payment of tuition fees are exempt from tax. The inheritance that a person receives after the death of a close relative is considered unearned income.
Generally, there is no income tax on inherited money, property, stocks, or other assets. In contrast, income from inherited rental properties or capital gains from investments sold are subject to tax.
7. Income from rental properties
Income from renting real estate is considered unearned income, but it is still taxable. Real estate rental expenses can be deducted from income and include , maintenance, insurance, taxes, utilities, supplies, repairs, etc.