The language of the U.S. tax code is filled with complex terminology, much of which can feel like a foreign language to the average taxpayer. One example of such jargon is “unearned income.”
The simplest definition of unearned income is that it refers to any income not classified as “earned,” but that doesn’t tell you much. To better understand the concept, let’s break it down and explore why distinguishing between earned and unearned income matters for your tax situation.
What Is Unearned Income?
Before diving into why unearned income is significant, it helps to understand what it includes. To provide some context, let’s first clarify the difference between earned and unearned income.
Earned income refers to money you receive through work or active participation in employment or business activities. It includes:
- Salaries and wages
- Tips
- Professional fees
- Taxable scholarship and fellowship grants
If you’re an employee, you’ll typically see this type of income reported on a W-2 form.
On the other hand, unearned income is money you receive from sources other than active work. Common examples of unearned income include:
- Taxable interest
- Ordinary dividends
- Capital gain distributions
- Unemployment compensation
- Taxable Social Security benefits
- Pensions and annuities
- Distributions from trusts
Unearned income is often (but not always) recorded on various 1099 tax forms, which makes identifying it relatively straightforward if you’re familiar with tax documents.
Why Does Unearned Income Matter?
While recognizing the difference between earned and unearned income is a big step, understanding how the distinction impacts your taxes is even more critical. That’s because the IRS treats these two types of income differently, and failing to categorize them correctly can carry costly tax implications.
Here are some key factors to consider:
1. Unearned Income Is Taxed At Different Rates
Most earned income is taxed at ordinary income tax rates, which range depending on your tax bracket. Unearned income, however, can fall under different tax rates. For instance:
- Long-term capital gains and qualified dividends are typically taxed at lower, preferential rates.
- These rates max out at 20%, but high-income earners might also face a 3.8% net investment income tax on some unearned income.
2. Kiddie Tax Rules Apply
If you’re a parent, you should be aware of the “kiddie tax.” This regulation shifts certain unearned income from a child’s lower tax bracket to the parent’s potentially higher tax rate. For 2023, the first $2,500 of a child’s unearned income is taxed at the child’s rate, but income above this threshold is taxed at the parent’s rate. This rule is particularly relevant for parents who set up investment accounts or trusts for their children.
3. Unearned Income May Limit Tax Benefits
Certain tax credits and deductions, like the Earned Income Tax Credit (EITC), impose restrictions on unearned income. For instance, to qualify for the EITC in 2023, your unearned income cannot exceed $11,000. Many homeowners, entrepreneurs, and investors overlook this detail when strategizing, only to realize later that their unearned income disqualifies them from claiming valuable credits.
4. Timing Circumstances Can Influence Tax Rates
Timing is everything when it comes to taxes—especially regarding unearned income. For example, if you sell an investment that has appreciated in value, holding it for just over a year could result in a significantly lower tax bill due to preferential capital gains rates. Strategic timing of events, like selling investments or triggering certain distributions, can help reduce your overall tax liability.
Navigating The Details: Why Professional Tax Planning Is Critical
Tax planning becomes significantly more complex when you’re dealing with multiple sources of income, especially a mix of earned and unearned income. Unfortunately, the IRS doesn’t make it easy to navigate all the nuances of the tax code. Ensuring you report your income correctly and take advantage of all possible tax benefits requires careful attention to detail and a solid understanding of tax law.
Working with an experienced tax professional is one of the best ways to understand how your unique mix of income might impact your finances. Professional advice can help you create a strategy to minimize your tax liability and maximize your financial well-being.
At Minton CPA & Associates, we specialize in tax planning for both individuals and businesses. Our experienced team can analyze your income structure and provide tailored strategies that save you money during tax season. Want to make the most of your unearned income?
Give us a call at 757-546-2870 to schedule a consultation today. We’ll help you navigate the complexities of the tax code with confidence and peace of mind.