Hey there! Are you someone who relies on investments or rental properties to generate income? You might already know it, but unearned income is taxed differently from your regular salary or wages. In fact, unearned income is subject to a special tax called the “net investment income tax” or NIIT for short.
The NIIT is a 3.8% tax on the lesser of your net investment income or the amount over the modified adjusted gross income (MAGI) threshold. It was introduced in 2013 as part of the Affordable Care Act and has been a point of contention among taxpayers ever since. The NIIT applies to income generated from assets like stocks, bonds, mutual funds, rental properties, royalties, and passive business activities.
So, if you’re in a situation where you’re making more money from your investments than from your day job, or you have rental properties that generate a sizeable income, you’ll definitely want to pay attention to how the NIIT works. In this article, we’ll cover everything you need to know about how unearned income is taxed and how you can minimize your tax bill. Stay tuned!
Definition of Unearned Income
Unearned income refers to the earnings that an individual receives from sources other than employment income. It includes income from various sources like investments, rental properties, gambling winnings, social security benefits, pensions, and stock dividends. This type of income is also referred to as passive income since it is not earned through active participation in work or business. Unearned income is subject to income tax, and the rate of taxation depends on the type and amount of income received.
Types of Unearned Income
Unearned income refers to any money that an individual receives without actively working for it. This type of income can be taxed differently from earned income, and it is important to understand the types of unearned income that are taxable in order to properly report it on your tax return.
- Interest Income: This is the money that you earn from interest payments on your savings account, CDs, or other investments. It is typically taxed at your ordinary income tax rate.
- Dividend Income: This is the money that you earn from owning stocks or mutual funds that pay out dividends. The tax rate on this income can vary depending on a number of factors, such as the length of time that you have held the investment and the tax bracket that you fall into.
- Rental Income: If you own property and rent it out, the income that you receive from the rent is considered unearned income. This income is subject to tax, but there are deductions that can be taken for expenses related to the rental property.
- Capital Gains: This is the money that you earn from selling assets such as stocks, real estate, or investments. The tax rate on capital gains varies depending on how long you have held the asset and your tax bracket.
It is important to note that not all types of unearned income are taxable. For example, certain government benefits such as Social Security or Veterans’ benefits are not subject to federal income tax.
Taxation of Unearned Income
There are different tax rates that apply to unearned income depending on the type of income that is being received. Interest income and rental income are typically taxed at the same rate as earned income, while dividend income and capital gains may be taxed at a lower rate depending on the length of time that the asset was held.
To determine the exact tax rate that applies to your unearned income, consult with a tax professional or refer to the IRS tax tables.
Reporting Unearned Income
Any income that is considered unearned must be reported on your tax return using the appropriate forms. For example, interest income will be reported on Form 1099-INT, dividend income on Form 1099-DIV, and rental income on Schedule E.
If you are unsure about how to properly report your unearned income, seek the guidance of a tax professional or consult with the IRS website for more information.
| Type of Income | Taxable? | Tax Rate |
|---|---|---|
| Interest Income | Yes | Ordinary income tax rate |
| Dividend Income | Yes | Varies based on investment and tax bracket |
| Rental Income | Yes | Ordinary income tax rate, with deductions for related expenses |
| Capital Gains | Yes | Varies based on investment and length of time held |
In conclusion, understanding the different types of unearned income and their tax implications is essential for accurately reporting this income on your tax return. Working with a tax professional can help ensure that you are taking advantage of any available deductions and minimizing your tax liability.
Tax Bracket for Unearned Income
Unearned income is often subject to different tax brackets than earned income. This is because unearned income, such as investment income, does not require active work to generate profits like earned income. Instead, it is often the result of an investment or other passive income source. As a result, the tax rates for unearned income are different from those for earned income. It’s important to understand these rates to avoid potential tax penalties or surprises at tax time.
- Currently, there are three main tax brackets for unearned income: 0%, 15%, and 20%. The exact bracket depends on the taxpayer’s total unearned income for the year and filing status.
- The 0% bracket applies to taxpayers who have less than $2,600 in unearned income if they are single or $5,200 if they are married and filing jointly.
- Taxpayers who earn between $2,601 and $12,749 of unearned income are subject to a 15% tax rate.
- Lastly, taxpayers earning over $12,750 of unearned income will face a tax rate of 20%.
It’s worth noting that these rates may change over time, especially during times of economic uncertainty or political shifts. Be sure to stay up-to-date on the current tax rates for unearned income to ensure that you are paying the appropriate amount and avoiding any potential tax penalties.
Here is a table to illustrate the current tax rates for unearned income based on filing status:
| Filing Status | 0% tax rate | 15% tax rate | 20% tax rate |
|---|---|---|---|
| Single filers | $2,600 or less | $2,601 to $12,749 | Over $12,750 |
| Married filing jointly | $5,200 or less | $5,201 to $22,549 | Over $22,550 |
Remember, proper tax planning can help you avoid any surprises come tax time and ensure that you are maximizing your after-tax earnings.
Difference between earned and unearned income taxation
Income is broadly classified into two types – earned and unearned. Earned income is the salary earned from your job or the income from your business. Unearned income, on the other hand, is the income you receive from sources other than your job or business. Examples include rental income, interest income, and dividend income.
- Earned income is taxed based on your income tax bracket. The more you earn, the higher the tax rate that applies to you.
- In contrast, unearned income is taxed at a different rate known as the capital gains tax rate. This tax rate is different from the ordinary income tax rate that applies to earned income.
- The capital gains tax rate is lower than the income tax rate for people who earn a high income. For investors who hold investments for more than a year, the long-term capital gains tax rate is even lower than the short-term capital gains tax rate for those who hold an investment for less than a year.
The table below shows the capital gains tax rates for 2021:
| Taxable Income | Short-Term Capital Gains Tax Rate | Long-Term Capital Gains Tax Rate |
|---|---|---|
| Up to $40,400 | 0% | 0% |
| $40,401–$445,850 | 15% | 15% |
| Over $445,850 | 20% | 20% |
It is important to understand the difference between earned and unearned income and how they are taxed. Proper tax planning can help reduce your tax burden and help you keep more of the income you earn.
Examples of Unearned Income Sources
Unearned income is a type of income that is not earned by performing services. Instead, it includes income from investments, rental property, and other sources. Here are some examples of unearned income sources:
- Stock dividends: Dividends paid out by companies to shareholders are considered unearned income. This includes both cash dividends and stock dividends.
- Interest income: Any interest earned on savings accounts, certificates of deposit, or other interest-bearing accounts is considered unearned income.
- Rental income: Income from rental properties, such as apartments, vacation homes, and commercial real estate, is considered unearned income.
- Capital gains: When you sell an asset, such as stocks or real estate, for more than you paid for it, the profit is considered a capital gain. This gain is considered unearned income.
- Trust income: Income earned from a trust, such as a revocable trust or a charitable trust, is considered unearned income.
It’s important to note that unearned income is still subject to taxation, just like earned income. The tax rate for unearned income can vary depending on the source and the amount of income earned.
A common misconception is that unearned income is taxed at a lower rate than earned income. However, this is not always the case. For example, long-term capital gains are taxed at a lower rate than short-term capital gains, but the tax rate for interest income is generally higher than the tax rate for earned income.
The Bottom Line
Unearned income can be a great way to diversify your income streams and build wealth, but it’s important to understand how it is taxed and plan accordingly. By knowing the sources of unearned income and the associated tax rates, you can make informed decisions about your investments and financial future.
| Income Source | Tax Rate |
|---|---|
| Capital gains (long-term) | 0%, 15%, or 20% |
| Capital gains (short-term) | Regular income tax rate |
| Interest income | Regular income tax rate |
| Rental income | Regular income tax rate |
| Stock dividends | Regular income tax rate or 15% |
The tax rates for unearned income can be complex, but understanding them can help you make better financial decisions and minimize your tax liability.
Taxation of Capital Gains
Capital gains refer to the profits one earns from the sale of capital assets such as property or stocks. The Internal Revenue Service taxes these gains, which are categorized as either short-term or long-term depending on the amount of time the asset was held. The tax on capital gains is unique in that it is only incurred when the asset is sold and not necessarily when it increases in value.
- Short-term Capital Gains: These occur when an asset is sold within a year of its purchase. They are taxed at the ordinary income tax rate, which means the tax rate varies depending on the taxpayer’s income level.
- Long-term Capital Gains: These occur when an asset is sold after being held for more than a year. They are taxed at lower rates than short-term gains, ranging from 0% to 20% depending on the taxpayer’s income level.
- Qualified Dividend Income: This is a type of income earned by owning stock that has been held for a certain period of time and pays dividends that are taxed at long-term capital gains rates.
The table below details the tax rates for long-term capital gains:
| Tax Bracket | Long-Term Capital Gains Tax Rate |
|---|---|
| 0% | Income up to $40,000 for individuals and $80,000 for married couples filing jointly |
| 15% | Income between $40,000 and $441,450 for individuals and between $80,000 and $496,600 for married couples filing jointly |
| 20% | Income above $441,450 for individuals and $496,600 for married couples filing jointly |
It’s important to note that some assets, such as tax-deferred retirement accounts, are not subject to capital gains taxes until they are withdrawn. Additionally, individuals who sell their primary residence may be eligible for a capital gains exclusion of up to $250,000 for individuals and $500,000 for married couples filing jointly.
Taxation of investment income
Investment income, also known as unearned income, is generated from investments such as stocks, bonds, mutual funds, and real estate. This type of income is taxed differently from earned income, which is income from a job or business. Investment income is subject to federal and state income tax, as well as additional taxes such as the Net Investment Income Tax (NIIT) and the Alternative Minimum Tax (AMT).
- Federal income tax: The federal government taxes investment income differently based on the type of investment. For example, interest income from bonds is taxed at the same rate as earned income, while long-term capital gains from stocks are taxed at a lower rate.
- State income tax: Most states also tax investment income, although the rates and rules vary by state.
- Net Investment Income Tax (NIIT): The NIIT is an additional 3.8% tax on the lesser of an individual’s net investment income or their modified adjusted gross income over a certain threshold. For 2021, the threshold is $200,000 for single filers and $250,000 for married filing jointly.
The AMT is a separate tax system that applies to certain taxpayers who have a high amount of deductions or credits. Taxpayers subject to the AMT may have to pay a higher tax rate on their investment income.
Investors should also be aware of tax-efficient investing strategies, such as tax-loss harvesting and investing in tax-advantaged accounts like Individual Retirement Accounts (IRAs) and 401(k)s. These strategies can help minimize taxes on investment income.
| Investment | Tax rate for long-term capital gains | Tax rate for short-term capital gains |
|---|---|---|
| Stocks | 0-20% | Up to 37% |
| Bonds | 0-37% | Up to 37% |
| Mutual funds | 0-20% | Up to 37% |
| Real estate | 0-20% | Up to 37% |
Investors should consult with a tax professional to understand the tax implications of their investment income and to develop a tax-efficient investment strategy.
Frequently Asked Questions: How Unearned Income is Taxed
1. What is unearned income?
Unearned income is money you receive that is not from traditional employment (i.e. wages or salary). Examples include investment income, rental income, and interest earned on savings accounts.
2. Is unearned income taxed differently than earned income?
Yes, unearned income is typically taxed at a different rate than earned income. The tax rate for unearned income depends on the type of income and your overall income level.
3. Do I have to pay Social Security and Medicare taxes on my unearned income?
No, Social Security and Medicare taxes only apply to earned income. Unearned income is not subject to these taxes.
4. Do I have to report all of my unearned income on my tax return?
Yes, you are required to report all of your unearned income on your tax return. Failing to do so can result in penalties and fines.
5. Are there any deductions or credits available for unearned income?
Yes, there are certain deductions and credits available for certain types of unearned income. For example, if you have rental income, you may be able to deduct expenses related to the rental property such as repairs and maintenance.
6. How can I reduce the amount of taxes I owe on my unearned income?
There are several strategies you can use to reduce the amount of taxes you owe on your unearned income. These include investing in tax-advantaged accounts, timing your sales of assets to minimize capital gains taxes, and taking advantage of deductions and credits.
Closing Thoughts
Thanks for taking the time to learn about how unearned income is taxed. Understanding the tax implications of your investments and other sources of unearned income is an important part of managing your finances. If you have any further questions, please don’t hesitate to reach out. And don’t forget to check back for more helpful articles in the future!