Do you have a source of income that the IRS considers to be 'unearned income'? Many Americans' taxes are affected by unearned income over the course of their lives, but they may not know how it actually works. To help you avoid surprise tax bills and trouble with the IRS, here are a few key things to know about unearned income.
1. Unearned Income Is Very Common
While you may feel like unearned income is something that only rich Americans have to worry about, it comes in many shapes and sizes. You may have unearned income if you get a pension, Social Security, gas or oil royalties, alimony, unemployment compensation, an annuity, or interest on an account. Because it's more pervasive than many people realize, you'll do well to keep an eye out for it so you can plan ahead for taxes.
2. Unearned Income Has Different Thresholds
To decide if you must file taxes at all during any given year, you would first look at the thresholds for filing. Both dependents (minors and adult individuals who are claimed) and retired persons may see different thresholds for earned and unearned income. If your child earns more than $1,100 in unearned income, for instance, they must file taxes. For earned income, this threshold is more than 10 times higher.
3. Unearned Income May Be Taxed Differently
While most unearned income is taxed similarly to your earned income, some of it does vary. Investments that are held for more than one year are often taxed as capital gains (rather than regular income), which may mean a lower tax rate for these earnings than your regular earnings. Similarly, Social Security may not be taxed at all depending on other sources of income.
4. Unearned Income May Not Count
The tax code sets out different rules for different credits and deductions. Sometimes, these rules stipulate whether or not you can count unearned income toward certain goals. For example, you generally can't include unearned income toward thresholds when calculating contribution limits for contributing to an IRA. And the Earned Income Tax Credit disallows many forms of unearned income.
5. Unearned Income Can Be Advantageous
Unearned income doesn't always result in a negative effect. For example, because long-term investments are taxed at a lower rate, they are part of a tax strategy to lower your effective tax bill. The simple act of selling assets that are more than one year old versus those that are less than one year old could reduce your taxes significantly. And some rental enterprises qualify as unearned income, creating a low-tax revenue stream for years.
Whether you face an unexpected influx of unearned income or you want to improve your tax strategy, the best place to begin is to meet with a tax preparation service or accountant in your state. Together, you can ensure that your unearned income minimizes taxes and maximizes potential.