The tax code uses jargon that can be confusing. One that impacts most of us is the term “unearned income.” But what is unearned income? It 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.

What is unearned income?

Before learning the definition, take a quick look at what is typically included in income in general.

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.

On the other hand, unearned income includes taxable interest, ordinary dividends, and capital gain distributions. It also includes unemployment compensation, taxable social security benefits, pensions, annuities, and distributions from a trust. Much of this income is often (but not always) recorded using 1099 tax forms.

Tax code considerations

If the tax code were simple, it wouldn’t matter how your income was defined. But this isn’t the case. Here are some things to consider:

1. Different tax rates. While most earned income is subject to ordinary income tax rates up to 37%, unearned income can be subject to different tax rates. For instance, long-term capital gains and certain dividends are subject to lower capital gains tax rates. These tax rates can max out at 20% before a potential net investment income tax of 3.8% is applied.
2. 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 $2,500 in 2023.
3. 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. For example, the Earned Income Tax Credit limits disqualified income to $11,000 in 2023.
4. 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 it is then taxed at capital gains tax rates.

It’s all in the details

It’s 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. For more information, feel free to contact our RRBB advisors.