No effort, no taxes Everything you need to know about passive income

Passive income is income that comes from sources that have nothing to do with work or personal effort.

Many people dream of living off passive income, such as investing in rental properties or dividend stocks. If you are lucky, you may inherit a huge fortune.

In a report published by the American "Investedwallet" website, author Prakash says that the sources of passive income are different from the source of fixed income that you receive from working in a full-time job.

Income from this type of income source is considered unearned income.

What is unearned income? How is it different from earned income?

Unearned income

Income from sources unrelated to work or personal effort. In contrast, salary, gratuities, self-employment, and some other sources are considered earned income. Making money blogging is also considered income, although some bloggers may think it is passive income.

The list of unearned income sources includes investment, dividends, capital gains distributions, retirement distributions, Social Security benefits, unemployment compensation, alimony, child support, lottery winnings, gifts, inheritance, veterans benefits, real estate income, fringe benefits, and more.

It is important to know the difference between earned and unearned income because they are taxed differently in many countries.

Earned income is subject to ordinary income tax and employment taxes, such as Social Security and Medicare.

Unearned income is not subject to ordinary income tax, but rather to capital gains tax. People do not pay employment taxes on unearned income.

Examples of unearned income

Example A : In the case of a person who earns a salary of $50,000 annually, then receives a bonus of $5,000, interest income from certificates of deposit of $2,000, and qualified dividends of $2,000, the salary and bonus are considered earned income, while the eligible interest and dividends unearned income. But all sources of income in this example are taxable.

Example B: A retiree receives $37,000 per year in Social Security benefits and $14,000 per year in pension payments, and the maximum benefit at full retirement age is $3,000 per month in 2021. In this case, both sources represent income unearned.

Types of Unearned Income

The list below represents the most common types of unearned income:

1. Investment income

Investment income represents income generated from the sale of real estate or shares. An investor who sells an asset for profit makes a capital gain. For the IRS, capital gains are considered unearned income. Investment income includes interest from savings, money market accounts, certificates of deposit and bond earnings. Tax rates on capital gains and interest income are different.

2. Long-Term Capital Gains Dividend

Mutual funds pay capital gains dividends to shareholders. This money comes from the sale of shares, bonds, or other assets owned by the mutual fund. Profits are distributed to shareholders as capital gains. And if the mutual fund falls under a taxable account, the shareholders must pay taxes on that unearned income.

3. Dividends

Dividend income comes from money paid to shareholders from dividends paid by companies. An investor can generate passive income and may even live on dividends. Regarding taxes, it depends on whether the dividends are ordinary or qualified. Ordinary dividends are subject to the ordinary income tax rate, while eligible dividends are taxed at 0%, 15% or 20%.

4. Retirement Income

Retirement income is derived from annuities, annuities, and distributions from retirement plans and individual retirement accounts. Social Security retirement benefits fall into this category.

Conventional financial IRA contributions are paid without any tax withholding, and taxes are levied when they are withdrawn, meaning this type of IRA is tax-deferred, and the investor gets a tax deduction when the contribution is made.

5. Unemployment benefits

Unemployment benefits are paid to individuals who have lost their jobs against their will. For example, a worker who lost his job during a mass layoff would receive unemployment benefits. This unearned income is designed to partially replace the lost income of the worker in order to provide for necessities while he is looking for another job.

6. Alimony and child support payments

Both alimony and child support payments are considered unearned income. But alimony payments are taxable in many cases, while child support payments are not included in taxable income.

7. Sweepstakes or prizes

Lottery winnings are considered unearned income. Similarly, winning in horse racing, sports betting and game shows is considered unearned income, because the participant has not made any effort to earn money.

8. Gifts and inheritance

Gifts are considered unearned income but are still subject to gift taxes in certain circumstances. From a tax perspective, gifts are a complex subject, so it is advisable to consult an expert. Gift taxes depend on the value of the gift, whether it is cash, property, stock, or other assets. In contrast, small monetary gifts are not subject to the gift tax.

Gifts to spouses and direct payment of tuition fees are tax-exempt. The inheritance that a person obtains after the death of a relative is considered unearned income.

In general, there is no income tax on inherited money, property, stock, or other assets. Income from inherited rental properties or capital gains from investments sold are also subject to tax.

9. Rental property income

Income from renting real estate is considered unearned income, but it is still taxable. Real estate rental expenses can be deducted from the income and they include advertising, maintenance, insurance, taxes, utilities, supplies, repairs, etc.