Understanding Tax Terms: Unearned Income

Not all income is the same in the eyes of the tax code

The tax code uses jargon that can be confusing for the unwary. One of them that impacts most of us is the term unearned income. Unearned income is often defined as anything that is not earned income. If you find this kind of definition a little too vague, here is some clarity.​

Tax code definition
Before providing the definition of unearned income, take a quick look at what is typically included in both earned and unearned income.
Earned income includes salaries, wages, tips, professional fees, and taxable scholarship and fellowship grants. Employees will typically see this recorded in an annual W-2 tax form.

Unearned income includes taxable interest, ordinary dividends, and capital gain distributions. It also includes unemployment compensation, taxable social security benefits, pensions, annuities, and distributions of unearned income from a trust. Much of this income is often (but not always) recorded using 1099 tax forms.

Why does it matter?
If the tax code was simple, it wouldn't matter one bit whether your income was earned income or unearned income. But this isn't the case. Here are some things to consider:

Different tax rates. While most earned income is subject to ordinary income tax rates up to 37%, unearned income can be subject to different tax rates. Long term capital gains and certain dividends, for instance, are generally subject to lower capital gains tax rates. These tax rates can max out at 20% before a potential net investment income tax of 3.8% is applied.

Kiddie tax rules. The tax code limits the amount of unearned income that can be taxed at your dependent's (usually lower) income tax rate. Amounts over this limit are taxed at the parent’s rate. The amount is $2,500 in 2023.
Tax benefit limits. Many tax credits and deductions will limit the amount of unearned income you may have and still qualify for a tax break. As an example, the Earned Income Tax Credit limits disqualified (unearned) income to $11,000 in 2023.

Timing matters. Sometimes the timing of an event can shift unearned income from ordinary income tax rates to preferential gain tax rates. This is the case with investment sales. Hold an investment for one year or less before selling it and your unearned investment gain is taxed as ordinary income. Hold it longer than one year and the unearned income is taxed at capital gains tax rates.

It's all in the details
It's important to understand how all elements of income apply to different aspects of the tax code. This is where working with someone familiar with the code can help.


"Tax Tips" are published to provide current tax information, tax-cutting suggestions, and tax reminders. If you would like more information on anything in "Tax Tips," or if you'd like to be on our mailing list to receive other tax information from time to time, please contact our office.
 
The tax information contained in this site is of a general nature and should not be acted upon in your specific situation without further details and/or professional assistance.
 
We are trusted CPA advisors servicing Burr Ridge, Hinsdale, Willowbrook, Darien, Naperville, and all Chicagoland area. 

Do you need assistance with your business and/or personal tax returns? Would you like to have a trusted source for your accounting, allowing you additional time to focus on increasing your business? Do you use QuickBooks, or plan to in the future, for your accounting? We include these in all our service packages, customized to fit your personal or business needs.  
 
We are currently accepting new clients. Your initial consultation is free, so you have nothing to lose and everything to gain. Our experienced staff is available to help you streamline your accounting, giving you more free time for yourself. Set up an appointment today by calling (630) 320-3720 or email us at info@monarchaccountinggroup.com. 
 
For more free resources, such as Tax Organizers, and Record Retention Schedules, access our website www.monarchaccountinggroup.com.

Mia Verc, CPA;  Janice Papais, CPA