If you’re constantly looking to diversify your sources of income, you may already know about passive income, the types of income that do not require active participation from the earner. Such income sources include rental income, dividends, and interest from investments. However, you also need to know that the IRS categorizes this type of income, released by your assets, as “unearned income.” As such, think of this income just like the money earned from an 8-to-5 job; you’ll be subject to paying federal and state taxes on it.
The amount of tax you’ll pay depends on where you live, how much you earn, and your filing status. For instance, if you’re a single taxpayer earning above $1,100 annually from interest or dividends, you may have to pay up to $80 in taxes. Even though it may not appear too massive, you need to consider that this is just on interest and dividends. If you have other unearned income, your tax burden could significantly increase.
Overall, it is essential to learn about the taxes you’re required to pay on unearned income if you want to stay compliant with the tax laws. Different categories of unearned income attract different taxation rates, and the best thing you can do is talk to a tax professional to help you understand your tax obligations further. However, if you have unearned income, you should nonetheless be prepared to part with a good chunk of it in taxes to support key state programs and services.
Understanding the Concept of Unearned Income
Unearned income is any income that is not earned through employment or self-employment. It includes investment income, rental income, and other passive incomes. Understanding the concept of unearned income is important because it affects how much taxes you pay and your overall financial planning. Here are some important things to keep in mind:
- Unearned income is typically taxed at a higher rate than earned income. This means that if you receive income from investments or rentals, you may be paying a higher percentage of your income in taxes than you would be if you were earning the same amount from a job.
- The type of unearned income you receive can also affect your tax rate. For example, long-term capital gains from investments are generally taxed at a lower rate than short-term capital gains. It’s important to understand the different tax rates and how they apply to your specific situation.
- If you have a high amount of unearned income, you may be subject to the net investment income tax (NIIT). This is an additional 3.8% tax on certain types of investment income, such as interest, dividends, and capital gains, for individuals with income over a certain amount.
Unearned Income and Taxes
When it comes to taxes, unearned income is generally taxed differently than earned income. Earned income is income that you receive from working, such as wages, salaries, and tips. Unearned income, on the other hand, includes things like:
| Type of Unearned Income | Examples |
|---|---|
| Investment income | Interest, dividends, capital gains |
| Rental income | Income from rental properties |
| Other passive income | Income from trusts, estates, partnerships, and S corporations |
The specific tax rules for unearned income depend on a variety of factors, including the type of income, the total amount of income you receive, and whether you are single or married filing jointly. It’s important to consult with a tax professional or use tax software to ensure that you are correctly reporting and paying taxes on your unearned income.
Types of Unearned Income that are Subject to Taxation
Unearned income is income received without performing any work to earn it. This type of income is subject to taxation because it is considered a form of passive income. Below are some examples of unearned income that are subject to taxation.
- Investment Income – This type of income includes dividends from stocks, interest from bonds, and capital gains from the sale of investments such as real estate or mutual funds.
- Rental Income – Any income you receive from renting out property you own is considered unearned income and is subject to taxation.
- Retirement Income – Income from pensions, annuities, and IRA distributions are all forms of unearned income and are subject to taxation.
It’s important to note that unearned income is taxed differently than earned income. Earned income is subject to both federal and state income tax, as well as Social Security and Medicare taxes. Unearned income, on the other hand, is only subject to federal income tax and the Medicare tax.
Below is a table outlining the tax rates for unearned income:
| Tax Rate | Single Filers | Married Filing Jointly |
|---|---|---|
| 0% | Up to $1,100 | Up to $2,200 |
| 15% | $1,101 – $12,750 | $2,201 – $25,500 |
| 20% | Over $12,750 | Over $25,500 |
As you can see, the tax rates for unearned income can be significantly lower than the tax rates for earned income depending on the amount of income you receive. However, it is still important to accurately report all of your income on your tax return to avoid any penalties or fines from the IRS.
Federal Income Tax Rates on Unearned Income
Unearned income refers to income that is earned through sources other than employment such as investments, rental income, or passive income from businesses. Taxes on unearned income are generally higher than taxes on earned income, especially for higher earners.
- The federal income tax rates on unearned income vary depending on the type of income. For example, long-term capital gains and qualified dividends are taxed at preferential rates compared to other types of unearned income.
- If unearned income is the taxpayer’s only income, the tax rates and brackets are different from those for individuals who have both earned and unearned income.
- Unearned income is subject to the Net Investment Income Tax (NIIT) of 3.8%, which was introduced in 2013 as part of the Affordable Care Act. The NIIT is levied on the lesser of either the taxpayer’s net investment income or the amount by which their modified adjusted gross income exceeds the threshold amount for their filing status.
In addition to federal taxes, there may also be state taxes on unearned income. However, the details of state tax rules and rates vary widely.
Here is a table that summarizes the federal income tax rates on unearned income for tax year 2021:
| Type of Income | Tax Rate |
|---|---|
| Ordinary dividends, interest, short-term capital gains, and most other unearned income | Same as tax rates for earned income (10% to 37%) |
| Long-term capital gains and qualified dividends | 0%, 15%, or 20% depending on taxpayer’s income level |
It’s important to note that these rates are subject to change and may depend on individual circumstances. It’s always a good idea to consult with a tax professional or financial advisor for personalized advice on how much taxes you’ll pay on your unearned income.
State Taxes on Unearned Income – Overview
When it comes to unearned income, many people often forget about state taxes. While federal taxes are important, state taxes can play a significant role in how much you owe on your unearned income. Here’s a closer look at state taxes on unearned income:
- Not all states tax unearned income: It’s important to note that not all states tax unearned income. As of 2021, seven states don’t have state income tax at all, which means you won’t have to worry about state taxes on your unearned income if you live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming.
- Some states tax some types of unearned income but not others: Even if your state does have an income tax, it might not tax all types of unearned income. For example, some states only tax interest and dividends but not capital gains or rental income.
- Tax rates vary by state: Just like federal income tax rates vary based on income, state tax rates on unearned income can also vary based on income. Some states have a flat tax rate, while others have a progressive tax system that taxes higher income earners at a higher rate.
State Income Tax Rates on Unearned Income
If your state does tax unearned income, it’s important to know what the tax rates are. Here’s a table that shows state income tax rates on various types of unearned income:
| State | Interest and Dividends Tax Rate | Capital Gains Tax Rate | Rental Income Tax Rate |
|---|---|---|---|
| California | 9.3% | 9.3% – 13.3% | 1% – 12.3% |
| New York | 4% | 4% – 8.82% | 4% – 8.82% |
| Illinois | 4.95% | 4.95% | 4.95% |
It’s important to note that these tax rates are subject to change, so be sure to check with your state’s tax authority to get the most up-to-date information.
Tax Planning Strategies for Unearned Income
Unearned income includes income from sources other than employment such as interest, dividends, capital gains, and rental income. Since unearned income is subject to taxes, it is essential to implement tax planning strategies to minimize its impact on your financial well-being.
In this article, we will discuss tax planning strategies for unearned income, including the following:
- Setting up a tax-efficient investment portfolio
- Maximizing retirement account contributions
- Investing in tax-advantaged accounts
Let’s explore each of these strategies in further detail.
Setting up a tax-efficient investment portfolio
When investing in stocks, bonds, or mutual funds, it is important to consider the tax implications of your investments. By investing in tax-efficient securities, you can reduce your tax liability and increase your after-tax returns. One way to accomplish this is by investing in low-cost index funds or exchange-traded funds (ETFs) that generate minimal capital gains distributions.
Maximizing retirement account contributions
Retirement accounts such as Individual Retirement Accounts (IRAs) and 401(k)s offer tax-deferred growth, which means that you don’t pay taxes on your investment gains until you withdraw from the account. By maximizing contributions to retirement accounts, you can reduce your taxable income and lower your tax liability. Additionally, many employers offer matching contributions to 401(k) plans, which can help boost your retirement savings even further.
Investing in tax-advantaged accounts
Tax-advantaged accounts such as Health Savings Accounts (HSAs) and 529 college savings plans offer tax benefits that can help reduce your overall tax bill. HSAs allow you to contribute pre-tax dollars to pay for qualified medical expenses, while 529 plans offer tax-free growth and withdrawals when used for qualified educational expenses.
| Account Type | Tax Benefit |
|---|---|
| Health Savings Account (HSA) | Pre-tax contributions and tax-free withdrawals for qualified medical expenses |
| 529 College Savings Plan | Tax-free growth and withdrawals for qualified educational expenses |
Implementing tax planning strategies for unearned income can help you minimize your tax liability and increase your net worth. By working with a qualified financial advisor and staying up-to-date on tax laws and regulations, you can develop a tax-efficient investment plan that meets your financial needs.
Tax Credits and Deductions on Unearned Income
Unearned income, such as dividends, interest, and rental income, can often be taxed at a higher rate compared to earned income. Fortunately, there are tax credits and deductions available to help offset the burden of taxes on unearned income. Here are some tax credits and deductions you can take advantage of:
- Foreign Tax Credit: If you receive income from foreign sources, you may be subject to foreign taxes. The foreign tax credit allows you to claim a credit for the foreign taxes you paid, which can lower your tax bill on your unearned income.
- Child Tax Credit: If you have dependent children, you may be eligible for the child tax credit. This credit can provide up to $2,000 per child under the age of 17, which can reduce your tax bill if you have unearned income.
- Earned Income Tax Credit: While not specific to unearned income, the earned income tax credit can provide a credit for low to moderate-income individuals. This credit can provide a significant benefit for individuals with unearned income if they meet the qualifications.
In addition to the tax credits above, there are also deductions that you can take advantage of to lower your taxable income:
- Investment Interest Expense: If you have investment income, you may be able to deduct the interest paid on loans used to generate that income. This deduction can help reduce your taxable income from unearned sources.
- Charitable Contributions: If you make charitable contributions, you may be able to deduct those donations on your tax return. This deduction can help reduce your taxable income from unearned sources while also supporting a good cause.
It’s important to note that some deductions and credits may have limits based on your income or the amount of income you receive from certain sources. It’s always a good idea to talk to a tax professional to determine which credits and deductions are best suited for your situation.
| Credit/Deduction | Description |
|---|---|
| Foreign Tax Credit | Credit for foreign taxes paid on unearned income |
| Child Tax Credit | Credit for dependent children under 17 |
| Earned Income Tax Credit | Credit for low to moderate-income individuals |
| Investment Interest Expense | Deduction for interest paid on loans used for investment income |
| Charitable Contributions | Deduction for donations made to qualified charitable organizations |
Overall, tax credits and deductions can significantly reduce the tax burden on unearned income. By taking advantage of the credits and deductions available to you, you can keep more of your hard-earned money in your pocket.
Common Myths about Unearned Income Taxation
Unearned income refers to any earnings that come from investments or non-work-related sources, such as dividends, rental income, or capital gains. While earned income is subject to payroll taxes and income tax, unearned income is taxed differently. However, there are many myths surrounding the taxation of unearned income:
- Myth #1: Unearned income is tax-free.
- Myth #2: Only the wealthy have unearned income.
- Myth #3: Unearned income is taxed at a lower rate than earned income.
- Myth #4: You don’t have to report unearned income on your tax return.
- Myth #5: You only have to pay taxes on unearned income once.
- Myth #6: You can avoid taxes on unearned income by reinvesting it.
- Myth #7: Unearned income is always taxed at a fixed rate.
This is simply not true. While some types of unearned income, such as municipal bond interest, may be tax-exempt, most unearned income is taxable at the federal and sometimes state levels.
While it’s true that those with higher incomes may have more opportunities for unearned income, anyone can earn income from investments, rental properties, or other sources.
It’s true that capital gains and dividends are taxed at a lower rate than regular income, but the rate varies depending on the amount of income and other factors. In some cases, unearned income may be taxed at a higher rate than earned income.
All income, including unearned income, must be reported on your tax return. Failure to do so can result in penalties and fines.
Unearned income may be subject to multiple taxes, including federal income tax, state income tax, and capital gains tax.
While reinvesting your unearned income may defer taxes until a later date, it does not eliminate them. You will eventually have to pay taxes on the income, even if you haven’t taken it out of the investment.
The tax rate for unearned income varies depending on the type of income and the amount earned. Here is a table showing some of the current tax rates for different types of unearned income:
| Type of Unearned Income | Tax Rate |
|---|---|
| Short-term capital gains (held for less than a year) | Regular income tax rate (up to 37%) |
| Long-term capital gains (held for more than a year) | 0%, 15%, or 20% depending on income level |
| Qualified dividends | 0%, 15%, or 20% depending on income level |
| Non-qualified dividends | Regular income tax rate (up to 37%) |
| Interest income | Regular income tax rate (up to 37%) |
How Much Taxes Do You Pay on Unearned Income?
1. What is considered unearned income?
Unearned income includes any income that does not come from employment or active participation in a business. It includes income from sources such as rental property, dividends, interest, and capital gains.
2. How is unearned income taxed?
Unearned income is typically taxed at a different rate than earned income. The tax rate for unearned income depends on the type of income received and your income tax bracket.
3. What is the current tax rate for unearned income?
The tax rate for unearned income varies depending on the source and amount of income. For example, capital gains are taxed at a different rate than rental income. In general, the tax rate for unearned income ranges from 0% to 20%.
4. Do I have to pay Social Security and Medicare taxes on unearned income?
Social Security and Medicare taxes only apply to earned income, not to unearned income. Therefore, you do not have to pay Social Security and Medicare taxes on income received from investments or rental property.
5. Are there any deductions or exemptions available for unearned income?
There are various deductions and exemptions available for unearned income, but they depend on the type of income and your personal circumstances. Some deductions and exemptions include investment expenses, rental property expenses, and retirement account contributions.
6. How can I minimize my tax liability on unearned income?
There are several ways to minimize your tax liability on unearned income, such as maximizing deductions and exemptions, tax-loss harvesting, and tax-efficient investment strategies.
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We hope this article has helped you better understand how much taxes you pay on unearned income. Remember, the tax rate for unearned income depends on the type of income received and your income tax bracket. If you have further questions or need assistance with your taxes, be sure to consult a tax professional. Thanks for reading and be sure to visit again for more informative articles!