Unearned Income

Unearned Income: What It Is and How It’s Taxed

Unearned income is money you receive without working for it. Unlike earned income (wages, salaries, tips, self-employment earnings), unearned income comes from investments or other passive sources. Common examples include interest, dividends, rental income, inheritances, and certain government benefits.

Key takeaways

• Unearned income is passive income—not compensation for labor or services.
• Tax treatment varies by type: some sources are taxed as ordinary income, others at capital gains rates, and a few may be tax-exempt.
• Most unearned income is not subject to payroll taxes (Social Security and Medicare).
• Unearned income often supplements earned income and can become the primary source of income in retirement.

Common types of unearned income

• Interest — from savings accounts, CDs, bonds, and loans. Generally taxed as ordinary income; interest from municipal bonds is usually exempt from federal income tax.
• Dividends — payments to shareholders. Ordinary dividends are taxed at ordinary rates; qualified dividends may be taxed at lower long-term capital gains rates if holding-period and issuer requirements are met.
• Capital gains — profits from selling investments held for varying periods; long-term capital gains are taxed at preferential rates.
• Rental and property income — rent from investment properties is treated as passive/unearned income (subject to special rules for losses and depreciation).
• Retirement distributions — withdrawals from 401(k)s, IRAs, pensions, and annuities (tax treatment depends on the account type and whether contributions were pre- or after-tax).
• Social Security, veterans’ benefits, welfare, unemployment compensation, lotteries, alimony, inheritances, gifts — these are generally treated as unearned income for tax and benefit purposes.

Taxation basics

• Tax rates depend on the source:
• Ordinary-taxed unearned income (most interest, ordinary dividends) is reported as ordinary income.
• Qualified dividends and long-term capital gains receive preferential (capital gains) rates if criteria are met.
• Some items (e.g., municipal bond interest) may be federally tax-exempt.
• Payroll taxes (Social Security/Medicare) typically do not apply to unearned income.
• Some unearned income sources allow tax deferral (for example, employer plans and certain annuities), which can reduce current tax liability.
• Contributions to IRAs generally require “earned” income; you typically cannot count unearned income as eligible compensation for IRA contributions.

Special rules: Children and the “kiddie tax”

The tax code treats some of a child’s investment income differently:
* Unearned income above certain thresholds may be taxed at parents’ rates under the “kiddie tax.”
* Under other IRS provisions, modest amounts of a child’s interest and dividend income may be reported on the parent’s return instead of on the child’s return. (Check current IRS thresholds and rules for exact amounts.)

Benefits of unearned income

• Provides supplemental cash flow before retirement and often becomes a primary source of income in retirement.
• Some unearned income can be tax-advantaged or deferred, helping with long-term planning.
• Diversifying income sources can smooth taxable income and reduce reliance on employment.

Examples

1. Jan places $50,000 in a CD. The interest she earns is unearned income and is taxable as ordinary income. If she also wins a cash prize, that prize is treated as unearned income and subject to tax.
2. Michael converts a property into two rental units and collects monthly rent from tenants. Those rent payments are passive (unearned) income and must be reported for tax purposes.

Practical tips

• Track the source and tax treatment of each type of unearned income.
• Consider holding investments that produce qualified dividends or long-term gains when favorable tax treatment is important.
• Use retirement accounts and tax-deferred vehicles wisely to manage timing of taxable distributions.
• Consult a tax professional if you’re unsure how a particular form of unearned income affects your tax return or eligibility for retirement contributions.

Bottom line

Unearned income is passive income earned without performing labor. It can come from investments, government benefits, gifts, and more. Tax rules vary widely by source, so accurate reporting and planning matter. When in doubt, review current IRS guidance or seek professional tax advice.