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What is Unearned Income?

In the world of taxation, income is broadly categorized into two main types: earned and unearned income. Earned income is derived from active participation in a trade or business. Conversely, unearned income encompasses various sources that don’t require direct effort or labor. This article explores the concept of unearned income, its sources, and how it is taxed. 

What is Unearned Income? 

Unearned income refers to any income not generated from active participation in a trade or business. Instead, it stems from investments, royalties, rents, dividends, interest, pensions, and other sources. The recipient doesn’t actively work to earn the income. It contrasts with earned income, which includes wages, salaries, and self-employment earnings. 

Sources of Unearned Income 

Let’s review some of the most common sources of unearned income and how they are taxed, if at all. 


Income from investments such as stocks, bonds, mutual funds, and real estate rentals constitutes a significant portion of unearned income. This can include capital gains from selling investments at a profit, dividends from stocks, and interest from bonds or savings accounts. Profits from the sale of investments, such as stocks, bonds, or real estate, are taxed as capital gains. The tax rate on capital gains ranges from 0-20% and depends on several factors. These include the holding period of the investment and the taxpayer’s income tax bracket. Generally, long-term capital gains, from assets held for more than a year, are taxed at lower rates than short-term capital gains. 

Dividend income is taxed at different rates depending on whether it is classified as qualified or ordinary dividends. Qualified dividends are taxed at the capital gains tax rates, which are typically lower than ordinary income tax rates. Ordinary dividends are taxed at the individual’s ordinary income tax rate. Interest income from sources such as savings accounts, CDs, and bonds is typically taxed at the individual’s ordinary income tax rate. However, certain types of municipal bonds may be exempt from federal income tax and, in some cases, state and local income tax. 


Individuals who own intellectual property rights, such as patents, copyrights, or trademarks, receive royalties when others use or license their creations. This passive income stream is a classic example of unearned income. Royalties and annuity payments are generally taxed as ordinary income. However, certain portions of annuity payments may be considered a return of the principal investment and are therefore not taxable. 


Income generated from owning and renting out real estate properties, whether residential or commercial, falls under unearned income. Landlords receive rental payments from tenants, providing a steady stream of income without active involvement in day-to-day operations. Rental income is subject to taxation at the individual’s ordinary income tax rate. Landlords are also allowed to deduct certain expenses related to renting out the property, such as mortgage interest, property taxes, maintenance costs, and depreciation

Pensions and Annuities 

Retirement income, including pensions and annuities, is often classified as unearned income. These payments are typically received after years of employment and represent a form of deferred compensation. Pensions and annuities are generally taxable at the federal level, although the taxation may vary depending on the specific circumstances and the type of plan. For example, if you contributed to the pension plan with pre-tax dollars, the entire amount of your pension payments is usually subject to income tax when you receive them. However, if you made after-tax contributions to the pension plan, a portion of your pension payments may be tax-free. 

Alimony and Child Support 

Payments made by one spouse to another as part of a divorce settlement (alimony) or for the support of children (child support) are considered unearned income for the recipient. However, they are typically not taxable for the recipient nor deductible for the payer.  

Lottery Winnings 

Windfalls such as lottery winnings, gambling winnings, or prizes from contests are considered unearned income and may be subject to taxation depending on the amount and jurisdiction. In addition, lump-sum winnings may be taxed at a higher rate than periodic payments. 

Employee Benefits 

Some employee benefits, such as employer-provided health insurance, life insurance, and certain fringe benefits, are considered unearned income. However, the tax treatment of these benefits varies depending on the specific benefit and applicable tax laws. 


Inherited assets, including money, property, or investments, are considered unearned income for the beneficiary. However, inheritance tax laws vary by jurisdiction, and in many cases, inherited assets may not be subject to income tax for the recipient. 

Tax Planning Strategies for Unearned Income 

Given the various sources and tax implications of unearned income, individuals can employ several strategies to minimize their tax liabilities. 

  1. Tax-Advantaged Accounts: Investing in retirement accounts such as 401(k)s, IRAs, or Roth IRAs can help defer or avoid taxes on investment gains, dividends, and interest income. 
  1. Tax-Loss Harvesting: Selling investments at a loss to offset capital gains can reduce taxable income from investments. However, it’s essential to be mindful of wash sale rules and other tax implications. 
  1. Asset Location: Placing investments with higher tax burdens, such as bonds generating interest income, in tax-advantaged accounts can optimize tax efficiency. 
  1. Qualified Dividends: Investing in stocks that pay qualified dividends can result in lower tax rates on dividend income compared to ordinary income tax rates. 
  1. Estate Planning: Utilizing trusts, gifting strategies, and other estate planning tools can help minimize estate taxes and transfer unearned income to heirs more efficiently. 

Tax Help for Those with Unearned Income 

Unearned income plays a significant role in the financial landscape, providing individuals with passive streams of income from various sources. Understanding the sources and taxation of unearned income is crucial for effective tax planning and wealth management. By leveraging tax-efficient investment strategies and taking advantage of available tax deductions and credits, individuals can optimize their financial situation and minimize their tax liabilities on unearned income. Optima Tax Relief is the nation’s leading tax resolution firm with over $3 billion in resolved tax liabilities.   

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