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What is Unearned Income?

The term “unearned income” (U.I.) refers to the income generated through sources other than the traditional source of employment. Such income sources include interest earned on deposits, dividends from stock investment, income from a rented property, gifts and contributions, etc. The taxation for U.I. is quite different from that of earned income, and the tax rate varies considerably based on such income sources.

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Explanation of Unearned Income

The underlying difference between unearned and earned income stems from how each income earns. Typically, earned income refers to the money paid to an individual against his/ her employment, profit generated from a business, or extra cash from a side hustle. On the other hand, U.I. is the opposite of earned income as it expects to generate without physical effort. In other words, it can be said that U.I. is the money generated from money.

Examples of Unearned Income

Different examples are below:

Example #1

Let us take the example of David to explain the computation of unearned income. During the year 2023, David was able to generate U.I. from several sources. He earned interest income at 4% on his bank deposits of $20,000. He also sold his house worth $50,000 for $60,000, resulting in capital gains. Further, he was unemployed during the year and received $3,500 as an unemployment allowance. Determine the U.I. earned by David during 2023.

Solution:

Given, Interest rate = 4%

Bank deposit = $20,000

Selling price = $60,000

Actual worth = $50,000

Unemployment allowance = $3,500

Now, interest income earned on bank deposits can calculate as,

Interest Income calculates as

Interest Income = Interest Rate * Bank Deposit

Interest Income = 4% * $20,000

Interest Income = $800

Capital Gain calculates as

Capital Gain = Selling Price – Actual Worth

Capital Gain = $60,000 – $50,000

Capital Gain = $10,000

Unearned Income = Interest Income + Capital Gain + Unemployment Allowance

Unearned Income = $800 + $10,000 + $3,500

Unearned Income = $14,300

Therefore, David earned a total U.I. of $14,300 from all the sources during 2023.

Example #2

Let us take the example of Jimmy, who works in a manufacturing plant as a Floor Manager. In 2023, he earned a salary of $70,000 and a performance bonus of $7,000. Besides, he also earned a dividend income of $6,500 from stock investment and an interest income of $5,000 from bank deposits. Determine the U.I. earned by Jimmy during 2023.

Firstly, it is essential to identify the sources of the U.I. in this case. Here, the income earned in the form of salary and performance bonus is related to employment and, as such, is considered to be earned income. On the other hand, the income earned in the form of dividends and bank interest is not related to employment and, as such, is a source of U.I.

Solution:

Given, Interest income = $5,000

Dividend income = $6,500

U.I calculate as

Unearned Income = $5,000 + $6,500

Unearned Income = $11,500

Therefore, Jimmy earned a total U.I. of $11,500 in 2023.

Types of Unearned Income

Although there are several sources through which U.I. can be generated, some of the familiar sources or types of unearned income are as follows:

Dividends earned from stock investment

Interest income from bank deposits

Rental income from owned property

Inheritances in cash or property

Gifts and contributions

Prize money, lottery winning, and awards

Settlements and court-ordered awards

Benefits offered by the Department of Veterans Affairs (V.A.)

Retirement and unemployment benefits extended by Railroad

Annuities and pensions from government sources

Unemployment insurance benefits

Benefits under Social Security policies

Proceeds from life insurance policies

Support provided in the form of alimony payments

All benefits extended by labor unions, such as Strike pay

Balance Sheet Advantages

In the case of unemployment, U.I. serves as the sole source of income.

In some instances, U.I. can be used to defer tax payments and avoid penalties from the Internal Revenue Service (IRS).

The U.I. is the passive source of income as it generates steady cash flow over time in exchange for little to no additional effort.

At the start, it takes a lot of effort to establish a source of U.I.

Any noticeable cash inflow starts after a significant period.

The tax rules for U.I. can be very complicated in some cases.

Conclusion

So, it can be seen that U.I. is a significant source of passive income for individuals as it ensures steady cash inflow in the long run and helps accumulate wealth. Besides, it also offers other benefits, such as tax deferment and avoidance of IRS penalties. However, one has to take the pain of setting up the source in the initial phase.