# What Is Unearned Income and How Is It Taxed?

![Unearned Income: Income not earned through employment.](https://www.investopedia.com/thmb/qXpzZqoIiV-IOPt-Z8wOA0e-0vU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/unearnedincome.asp-final-aa90a48dd1c340eb9ccc4329cec05fad.png)

**

## What Is Unearned Income?

Unearned income refers to any [income](https://www.investopedia.com/terms/i/income.asp) that is earned passively, without performing work or providing a service. In contrast to earned income, which comes from wages, salaries, and business activities, unearned income is derived from investments or other sources where no labor is involved. Common examples of unearned income, or [passive income](https://www.investopedia.com/terms/p/passiveincome.asp), include interest from savings accounts, dividends from stocks, and rental income from properties.

### Key Takeaways

*   Unearned income is passive income that is not acquired through work or business activities.
*   Examples of unearned income include inheritance money and interest or dividends earned from investments.
*   Tax rates on unearned income are different from rates on earned income.
*   While unearned income may supplement earned income before retirement, it often becomes the primary source of income in retirement years.

## Understanding Unearned Income

Unearned income is typically earned through investments, such as interest on savings, dividends from stocks, or income from rental properties. Unlike [earned income](https://www.investopedia.com/terms/e/earnedincome.asp), which includes wages and self-employment earnings, unearned income is not tied to labor.

Unearned income cannot be contributed to [individual retirement accounts (IRAs)](https://www.investopedia.com/terms/i/ira.asp). According to the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp), earned income includes wages, salaries, tips, and self-employment income.

[Taxation](https://www.investopedia.com/terms/t/taxation.asp) differs for unearned income and earned income due to qualitative differences. The [tax rates](https://www.investopedia.com/terms/t/taxrate.asp) also vary among unearned income sources. Most unearned income sources are not subject to [payroll taxes](https://www.investopedia.com/terms/p/payrolltax.asp), and none of it is subject to employment taxes, such as Social Security and Medicare.

> **Important**
>
> Make sure you understand the origin and taxation of any of your unearned income.

## Types of Unearned Income

Unearned income can fall into a number of different categories. Below are some of the most common types:

### Interest

[Interest](https://www.investopedia.com/terms/i/interest.asp) income from savings accounts, bonds, loans, and [Certificates of deposit (CDs)](https://www.investopedia.com/terms/c/certificateofdeposit.asp) is considered unearned income. This type of income is typically taxed as [ordinary income](https://www.investopedia.com/terms/o/ordinaryincome.asp).

There are certain exceptions to this rule, including interest earned on [municipal bonds](https://www.investopedia.com/terms/m/municipalbond.asp), which is exempt from [federal income tax](https://www.investopedia.com/terms/f/federal_income_tax.asp).

### Dividends

[Dividends](https://www.investopedia.com/terms/d/dividend.asp), which are income from investments, can be taxed at ordinary tax rates or preferred [long-term capital gains tax](https://www.investopedia.com/terms/c/capital_gains_tax.asp) rates. Investments typically yield dividends payable to shareholders on a regular basis. Dividends may be paid to the investment account monthly, quarterly, annually, or semi-annually.

Taxation of dividends is based on whether the dividend is ordinary or qualified:

*   [Ordinary dividends](https://www.investopedia.com/terms/o/ordinary-dividends.asp), the more common form of dividends that investors receive from a company, are taxed at ordinary tax rates.
*   [Qualified dividends](https://www.investopedia.com/terms/q/qualifieddividend.asp) are taxed at the more favorable capital gains tax rates. In order to qualify as qualified dividends, they must be issued by a U.S. corporation or qualified foreign corporation, the investor must own them for at least 60 days out of a 121-day holding period, and they cannot be in a category of dividends otherwise excluded from the qualified dividend classification.

### Other Sources of Unearned Income

You may get unearned income from other sources, such as:

*   Retirement accounts like [401(k)s](https://www.investopedia.com/terms/1/401kplan.asp), pensions, and [annuities](https://www.investopedia.com/ask/answers/12/what-is-an-annuity.asp)
*   [Inheritances](https://www.investopedia.com/terms/i/inheritance.asp)
*   [Alimony](https://www.investopedia.com/terms/a/alimony.asp)
*   Gifts
*   Lottery winnings
*   Veterans Affairs benefits
*   Social Security benefits
*   Welfare benefits
*   [Unemployment](https://www.investopedia.com/terms/u/unemployment.asp) compensation
*   Property income

## Benefits of Unearned Income

Unearned income can serve as a supplement to earned income before [retirement](https://www.investopedia.com/terms/r/retirement.asp), and it is often the only source of income in postretirement years. During the accumulation phase, taxes are deferred for many sources of unearned income.

Sources of unearned income that allow a deferment of income tax include [401(k) plans](https://www.investopedia.com/terms/1/401kplan.asp) and annuity income. As a result, participants avoid IRS penalties and higher tax rates.

> **Tip**
>
> Tax advisors often recommend diversifying holdings to even out the effect of taxes on unearned income.

## Examples of Unearned Income

Here are a couple of hypothetical examples to show how unearned income actually works.

### Example 1

Let's say Jan invests $50,000 in a CD. The interest she derives from her investment is considered unearned income and must be reported to the IRS for taxation at the ordinary income rate. She also wins $10,000 on a game show, but she does not get the full amount of her winnings. Why? Because the IRS deducts taxes from it, treating the amount as unearned income.

### Example 2

Let's suppose Michael buys an [investment property](https://www.investopedia.com/terms/i/investment-property.asp) with the intention of renting it out for additional income. He fixes it up and converts it into two apartments: the main unit and the basement as a separate studio. He signs leases with two different tenants who pay their rent to Michael on the first of each month. The tenants' rent payments are considered unearned or passive income because Michael isn't doing any work to earn them.

## What's the Difference Between Unearned Income and Earned Income?

Unearned income is any form of income you earn passively. Examples include interest on investments, dividends, lottery or casino winnings, and rental income from investment properties. Earned income, on the other hand, is any compensation you receive for providing a service. This may be from your employer, a [self-employment](https://www.investopedia.com/terms/s/self-employed.asp) gig, tips, bonuses, and vacation pay.

## Do I Have to Pay Tax on Unearned Income?

Usually, yes. Though not subject to employment taxes, such as Social Security and Medicare, and, in most cases, payroll taxes, unearned income is generally treated as taxable income—save for a few exceptions such as [life insurance](https://www.investopedia.com/terms/l/lifeinsurance.asp) proceeds.

## How Much Tax Will I Pay on Unearned Income?

Unearned income is not taxed uniformly. Some sources of unearned income are taxed as ordinary income, whereas others enjoy more generous tax rates. It's also possible with some types of unearned income to defer tax liabilities to a later date.  

## What Is the Tax Treatment of Unearned Income for a Child?

According to the IRS, there are two possibilities that affect the reporting of a child's unearned income. Any unearned income above $2,600 may be subject to an unearned income tax. This is known as the [kiddie tax](https://www.investopedia.com/terms/k/kiddietax.asp). Alternatively, interest and dividend income of less than $13,000 may be included on the parent's return rather than that of the child.

## The Bottom Line

Unearned income isn't a term with which most people are familiar. You may know it as passive income or money that you acquire without providing a service. Put simply, you make this money without actually working for it.

Sources of unearned income may include interest income from interest-paying accounts, dividends, and rent from tenants if you have an investment property. Just because it means it is earned passively doesn't mean you don't have to report it on your [tax return](https://www.investopedia.com/ask/answers/051415/what-are-different-ways-i-can-file-my-income-tax-return.asp). In fact, the opposite is true. Be sure to check with the IRS or the issuer of the unearned income, or you can consult a tax professional if you're unsure of what your unearned means to your tax liability.

> **Article Sources**
>
> 1.  Internal Revenue Service. "[Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)](https://www.irs.gov/pub/irs-pdf/p590a.pdf)," Pages 6-7.
>     
> 2.  Internal Revenue Service. "[Publication 17, Your Federal Income Tax For Individuals](https://www.irs.gov/pub/irs-pdf/p17.pdf)," Pages 44-74.
>     
> 3.  Social Security Administration. "[What Income Is Included in Your Social Security Record?](https://www.ssa.gov/benefits/retirement/planner/annuities.html)"
>     
> 4.  Internal Revenue Service. "[Topic No. 403, Interest Received](https://www.irs.gov/taxtopics/tc403)."
>     
> 5.  Internal Revenue Service. "[Publication 550, Investment Income and Expenses](https://www.irs.gov/pub/irs-pdf/p550.pdf)," Page 11.
>     
> 6.  Internal Revenue Service. "[Topic No. 404, Dividends](https://www.irs.gov/taxtopics/tc404)."
>     
> 7.  Internal Revenue Service. "[Publication 550, Investment Income and Expenses](https://www.irs.gov/pub/irs-pdf/p550.pdf)," Page 19.
>     
> 8.  Social Security Administration. "[Social Security Handbook: 2136. What is “Unearned Income”?](https://www.ssa.gov/OP_Home/handbook/handbook.21/handbook-2136.html)"
>     
> 9.  Financial Industry Regulatory Authority. "[Annuities: Overview](https://www.finra.org/investors/investing/investment-products/annuities#overview)."
>     
> 10.  Financial Industry Regulatory Authority. "[Retirement Accounts: Types](https://www.finra.org/investors/investing/investment-accounts/retirement-accounts#types)."
>      
> 11.  Internal Revenue Service. "[Publication 525, Taxable and Nontaxable Income](https://www.irs.gov/pub/irs-pdf/p525.pdf)," Page 36
>      
> 12.  Internal Revenue Service. "[Publication 17, Your Federal Income Tax For Individuals](https://www.irs.gov/pub/irs-pdf/p17.pdf)," Pages 52-59, 65-74.
>      
> 13.  Internal Revenue Service. "[Topic no. 553, Tax on a Child's Investment and Other Unearned Income (Kiddie Tax)](https://www.irs.gov/taxtopics/tc553)."