Unearned income is earned from sources unrelated to employment and includes interest income, dividends, rental income, gifts, and contributions. In addition, its taxation differs from that of the earned income, and tax rates may also vary among the different sources. For a company, it is accounted as a liability as most often, the work is pending.
Unearned income tax is collected for income that is made through sources other than the primary source of income for the taxpayer. Interest, dividends, social security benefits, capital gains, pensions, and unemployment compensations are a few examples of the same. However, it is only included in the Adjusted Gross Income (AGI) and not in the income statement.
Unearned income is the income received from investments or other sources unrelated to employment. The different examples include interest received from the investment, dividends, royalties, and pension funds. In all the mentioned examples, the income is not derived from the means that require the personal effort of the person, so they are categorized as unearned income.
Such income from many of the sources helps in deferring taxes and avoiding the penalties of the IRS. However, income earned from various sources may have different tax rates. Therefore, it is preferable to diversify the holdings to even out the effect of the applicable taxes.
Types
To understand the intricacies of unearned income accounting in depth, it is important to understand its types. Let us do so through the explanation below.
#1 - Interest Income
Interest income is the income that investors earn on their investment over the period. Examples of interest income can be the income earned from savings deposit accounts, certificates of deposits, loans, etc.
#2 - Dividends
The dividend is the income earned from the investments that may be taxed at the ordinary rate of taxation or the tax rate on the long-term capital gains. Dividend income is received from the investments in the company, which gives the dividend to its shareholders. Each of the shares in the company gets a percentage of the company's profit.
#3 - Rental Income
Rental income is a person's income when he rents out his property to another person. The other person pays an amount to the property owner for using the owner's assets. This income derives from means other than the person's effort and is treated as unearned income.
#4 - Gifts and Contributions
Gifts and contributions are the amounts received in cash or kind by a person from the other person. In the case of gifts and contributions, people earn income from sources unrelated to employment, which is treated as an unearned income.
There are other types as well, which include annuities, prizes, lottery winnings, Proceeds of insurance policies, alimony payments, Welfare benefits, inheritance, Retirement accounts, etc. In all such cases, income is earned by the person from sources unrelated to the employment and does not require personal efforts, so they will be treated as unearned income.
Examples
Understanding unearned income tax and its implications can be a tricky task. Therefore, let us take the help of a couple of examples as discussed below.
Example #1
Jill is working in a manufacturing company as the manager of the company. During the month, he earned a salary of $65,000 and a performance bonus of $9,000 from the company. Apart from these, he also earned $5,000 as dividend income and $10,000 as the interest income during the same month. Therefore, the income earned by Jill from the sources related to the employee will be considered the earned income, and the income earned from the sources not related to the employee will be regarded as the unearned income.
In the present case, salary and performance bonus is employment-related earnings involving personal effort. Hence, it will be treated as the earned income. The income from dividends and interest is unrelated to employment and does not include personal effort, so it will be considered unearned.
Therefore calculation of earned income using below formula is as follows,
Unearned Income = Dividend Income + Interest Income
= $5,000 + $10,000
= $15,000
Jill's salary and bonus income will be taxed differently than his income from dividends and interest.
Example #2
In March 2023, President Joe Biden announced the government’s plan to increase the Medicare tax for high income individuals. It was said that people who are well-off can pay “just a little bit” more to solve medical healthcare problems for everyone in the country.
The proposal is to increase the tax from 3.8% to 5% and unearned income beyond $400,000. These changes are forecasted to cure the solvency issues of the Hospital Trust Insurance Fund by 25 years.
Advantages
Fully understanding the concept would require us to understand its advantages and in detail. Let us do so through the discussion below.
After retirement, it is the only source of income.
Unearned income from many sources helps in deferring taxes and avoiding the penalties of the IRS.
It requires little continuous effort to maintain. Often it requires an initial effort of a considerable amount to create such a source of income. Still, once created after the initial efforts, it gives income over time with little or no additional effort.
Importance
Let us understand the importance of unearned income accounting and its implications through the explanation below.
This income is not typically subject to payroll tax, employment tax.
In the initial period of creating the source of unearned income, additional efforts and investments are required, and payment received against such efforts is also not immediate. But once the source of other income is created after the initial efforts, unearned income from many sources gives income over the period with little or no additional effort.
There may be different tax rates for the income earned from various sources.
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