Paul Newman once said, “Money won is twice as sweet as money earned.”

Everyone likes money that comes without expending a great deal of effort. Unearned income is passive or supplemental income that might include social security benefits, unemployment, annuities, pensions, and trust funds.

It also includes taxable interest and capital gains, and even gambling and lottery winnings. Any dividends you earn from investments, like stocks and mutual funds, are considered unearned income.

If you’re retired, this type of income might be your only source of income. Plus, when added to your earned income, it can boost your peace of mind in hard times. However, you can’t use unearned income to add to your IRA, which must come from earned income. But if you’re married, filing jointly, you can also consider your partner’s income when contributing to your IRA.

Taxes on Unearned Income

Unearned or passive income is determined by your marginal tax rate or whatever tax you pay at your federal tax bracket. While you’ll pay social security/medicare taxes and income taxes on earned income, you pay no payroll taxes on unearned income.

Let’s say you’re a teacher who earns $35,000 per year (less than you should be paid for the work you do), and you also get a pension from the Teacher’s Union. That means you are making both earned—your paycheck—and unearned—your pension— income.  

But because unearned income adds to your adjusted gross income (AGI), it still adds to your total tax burden and may also be subject to capital gains tax. Capital gains and stock dividends are taxed at a lower rate than other types of unearned income taxed at your marginal tax rate, which adjusts every year, taking inflation into account.  

What is Earned and Unearned income?

If you have a job and earn a regular paycheck, the money deposited into your bank account is earned income. If you have a job and earn a steady salary and your employer also offers a retirement or pension account, you are earning both earned and unearned income. Your wages are earned income, and your retirement account or pension is unearned or passive income. At the same time, let’s say you invest in stocks on the side. Both your retirement account and any dividends earned on stock investments are also unearned income.

Is Rent Earned or Unearned Income?

Because the IRS has a way of complicating matters, income from rent can be both passive and earned and depends on several factors. First up is the level of involvement you have in the whole process.

• Do you own more than 10% of the property?
• Do you actively make improvements?
• Are you in charge of finances?
• Do you select tenants and make management decisions?

For example, John earns $55,000 per year as a cook at a resort. He rents out his on-site apartment for $1,800 per month during the winter months when the resort is closed. The $55,000 yearly income is earned income. The $1,800 per month ($1,800 x 12) or $21,600 is unearned income. The only time rent is considered earned income is when you are in the business of renting property and collecting rent payments from your customers. Concerning taxes, even this definition is a bit muddy.

Besides that, you may not have to worry about passive or earned income under Rule 14. This Rule states that if you rent your property for less than 14 days a year, there’s no need to report the money you earned to the IRS. Fourteen days is the minimum that the IRS looks at to decide if you intend to get actively involved in the property or simply earn a bit of extra cash.

Types of Unearned Income

Unearned income is any money that is not earned from your job or your business, according to the American Social Security Administration. Several common types of unearned income include:

• Alimony. For the support of one partner to the other partner after a divorce.
• Pensions and annuities. This might include disability or veterans benefits, workman’s comp, and other income that may be related to your job.
• Rent. This does not include money earned if you are in the business of renting properties, but only if you causally rent out a room, apartment, or condo that is also used as your residence for part of the year.
• Dividends, certain royalties, and interest earned. This might include stocks, savings accounts, bonds, or royalties earned from a book deal.
• Awards and prizes. Something you win, like $1,000 at a blackjack table or a monetary award.
• Your inheritance. This is money you receive that is not related to a service you provided or goods you produced.
• Death benefit. Any money not spent on a person’s last illness or burial is considered unearned income.
• Social security benefits. At retirement, you sign up for social security benefits, which are paid based on your accrued income.
• Unemployment benefits. Any money you receive from unemployment while unemployed is considered unearned income.
• Veterans (VA) benefits. Money earned from serving in the military that is not considered salary.
• ‍Life insurance benefits. Any proceeds from a life insurance policy upon the death of the insured.

Types of Earned Income

Earned income comes from the money you make from some type of effort and includes salary, wages, commissions, bonuses, tips, and earnings from self-employment, wages, salaries, bonuses, commissions, tips, and net earnings from self-employment. Other types of earned income include:

• Vacation pay
• Severance pay
• Benefits or pay from a union strike
• Long-term disability benefits

Does Unemployment Count as Earned or Unearned Income‍

Due to COVID-19, unemployment numbers have skyrocketed, leveled out, and jumped again. Unfortunately, if you received an unemployment check, you’ll be required to pay taxes on that money. It’s a separate line item from any wages earned in the year.

That said, if you qualify, the Earned Income Tax Credit (EITC) might come in handy.  The EITC is a federal tax credit that depends on your income, or you and your partner’s income level and is meant to help moderate-income individuals or families.

Similarly, any income earmarked for the Supplemental Nutrition Assistance Program (SNAP), historically called Food Stamps, is not included in your gross or net income.

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Unearned Income Benefit for Retirees

Other than a source for extra revenue, unearned income might be the only source of income for retirees. While acquiring income, taxes are deferred for most sources of unearned income, like annuities and 401(k) plans. That way, you avoid paying taxes at a higher tax rate. Depending on how much your spend and how much you already have in savings, might help you determine the assets and cash you need on-hand to retire.