What Is Unearned Income: Not All Income Is the Same When It Comes to Taxes

The tax code uses terms that can be confusing. One of them that impacts most of us is the term “unearned” income. Unearned income is often defined as anything that is not “earned” income. If you find this kind of definition a little too vague, here is some clarity:

• Earned income includes salaries, wages, tips, professional fees, and taxable scholarship and fellowship grants. Employees will typically see this recorded in an annual W-2 tax form.
• Unearned income includes taxable interest, ordinary dividends, and capital gain distributions. It also includes unemployment compensation, taxable social security benefits, pensions, annuities, and distributions of unearned income from a trust. Much of this income is often (but not always) recorded using 1099 tax forms.

Why does it matter?
If the tax code was simple, it would not matter one bit whether your income was earned income or unearned income. But this is not the case. Here are some things to consider:

• Different tax rates. While most earned income is subject to ordinary income tax rates up to 39.6%, unearned income can be subject to different tax rates. Long term capital gains and certain dividends, for instance, are generally subject to lower capital gains tax rates. These tax rates can max out at 20% prior to applying Affordable Care Act tax provisions.
• Kiddie tax rules. The tax code limits the amount of unearned income that can be taxed at your dependent's, usually lower, income tax rate. Amounts over this limit are taxed at the parent’s rate. The amount is $2,100 in 2016.
• Tax benefit limits. Many tax credits and deductions will limit the amount of unearned income you may have and still qualify for a tax break. As an example, the Earned Income Tax Credit, limits disqualified (unearned) income to $3,400 in 2016.
• Timing matters. Sometimes the timing of an event can shift unearned income from ordinary income tax rates to preferential gain tax rates. This is the case with investment sales. Hold an investment for one year or less before selling it and your unearned investment gain is taxed as ordinary income. Hold it longer than one year and the unearned income is taxed at capital gains tax rates.

It's all in the details. It is important to understand how all elements of income apply to different aspects of the tax code. This is where working with someone familiar with the code can help.