Updated July 11, 2023
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.
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 2019, 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 2019.
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 calculates as
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 2019.
Example #2
Let us take the example of Jimmy, who works in a manufacturing plant as a Floor Manager. In 2019, 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 2019.
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 = Interest Income + Dividend Income
- Unearned Income = $5,000 + $6,500
- Unearned Income = $11,500
Therefore, Jimmy earned a total U.I. of $11,500 in 2019.
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
The unearned income is due but yet to be received is captured as an asset in the balance sheet. To record the journal entry for U.I., the U.I. receivable account should be debited, and the unearned income account should be credited. When the income is realized, the cash should be debited, and the unearned income receivable account should be credited to the journal entry.
Advantages
Some of the significant advantages of U.I. are as follows:
- 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.
Disadvantages
Some of the significant disadvantages of U.I. are as follows:
- 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.
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