DEFINITION: The phrase “unearned income” refers to any earnings that do not result from services rendered, commonly known as “employment.”
This definition contrasts with “earned income,” which signifies earnings received for services rendered.
Unearned, also known as “passive,” income can take various forms, such as interest from savings accounts, stock dividends, bond yields, rents, and alimony.
ETYMOLOGY: The concept of unearned income was already adumbrated by Jeremy Bentham in the 1790s. However, the phrase itself seems to have been coined by John Stuart Mill in 1865 in his book Principles of Political Economy. It was popularized by Henry George in his 1879 book Progress and Poverty.
The English adjectives “unearned” and “earned,” from the verb “to earn,” are attested from around the eleventh century. The verb “to earn” derives from Middle English ernen and Old English earnian, both with the same meaning.
The English noun “income” is attested from the fourteenth century. It is composed on the preposition “in” used as a prefix and the verb “to come.”
“In” is attested from the eleventh century. It derives from identical Middle English and Old English forms. The Old English word in is akin to Old High German in, with the same meaning.
The English verb “to come” is also attested from the eleventh century. It derives from Middle English comen and Old English cuman, which is akin to Old High German queman, all meaning “to come.”
USAGE: The Internal Revenue Service (IRS) defines earned income as wages, salaries, tips, and self-employment earnings. It should be noted that unearned income is ineligible for contribution to individual retirement accounts (IRAs).
Taxation of earned income and unearned income differs due to the inherent distinction between them.
In addition, tax rates on different sources of unearned income may differ to a considerable degree. For example, most sources of unearned income are typically exempt from payroll taxes, and no source of unearned income is subject to employment-related taxes, such as Social Security and Medicare contributions.
Types of Unearned Income
1. Interest: Interest and dividend earnings stand out as the prevailing categories of unearned income. Earnings acquired through these means are categorized as unearned income, with the associated tax classified as unearned income tax.
Among the types of income-generating sources subject to taxation as ordinary income are checking and savings deposit accounts, certificates of deposit (CDs), and loans. However, exemptions exist, such as the interest accrued from municipal bonds, which is not subject to federal income tax.
2. Dividends: Dividends, which constitute income derived from investments, may be subject to either standard tax rates or the more-favorable long-term capital gains tax rates.
Investments typically generate dividends that are disbursed to shareholders on a regular basis. Dividends may be distributed to investment accounts on a monthly, quarterly, semi-annual, or annual basis.
The taxation of dividends depends on whether they are categorized as ordinary or qualified:
- Ordinary dividends, whichare the prevalent type of dividends disbursed to investors by companies, are subjected to regular tax rates.
- Qualified dividends, in contrast, are subject to the more-advantageous capital gains tax rates. To qualify for this status, dividends must meet several additional conditions.
Other Sources of unearned income include:
- Retirement accounts, including pensions, 401(k)s, and annuities
- Inheritances
- Property income
- Gifts
- Alimony
- Unemployment compensation
- Welfare benefits
- Social Security benefits
- Veterans Affairs (VA) benefits
- Lottery winnings