One IRS term that confuses many and yet impacts most of us is the phrase "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, let us provide 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 whether your income was earned or unearned. But since 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. 

Consider Timing. 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

If you would like to know more about how different elements of income are taxed, click here to schedule an appointment with one of Gold Standard's seasoned tax accountants.

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