What is Unearned Income?
The term “unearned income” (U.I) refers to the income generated through sources other than the traditional source of employment. The sources for such income include interest income earned on deposits, dividends from stock investment, income from a rented property, gifts and contributions, etc. The taxation for U.I is quite different to that of earned income and the tax rate also varies quite a lot based on the sources of such income.
Explanation of Unearned Income
The underlying difference between unearned income and earned income stems from the way each income is earned. Typically, earned income refers to the money paid to an individual against his/ her employment, profit generated from a business, or extra cash earned from a side hustle. On the other hand, U.I is exactly the opposite of that of earned income as it is expected to be generated without any kind of physical effort. In other words, it can be said that U.I is the money generated from money.
Examples of Unearned Income
Following examples are given below:
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 the rate of 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 in the form of an unemployment allowance. Determine the U.I earned by David during 2019.
- 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 deposit can be calculated as,
Interest Income is calculated as
Interest Income = Interest Rate * Bank Deposit
- Interest Income = 4% * $20,000
- Interest Income = $800
Capital Gain is calculated as
Capital Gain = Selling Price – Actual Worth
- Capital Gain = $60,000 – $50,000
- Capital Gain = $10,000
Unearned Income is calculated as
Unearned Income = Interest Income + Capital Gain + Unemployment Allowance
- Unearned Income = $800 + $10,000 + $3,500
- Unearned Income = $14,300
Therefore, David was able to earn a total U.I of $14,300 from all the sources during the year 2019.
Let us take the example of Jimmy who works in a manufacturing plant as a Floor Manager. During the year 2019, he earned a salary of $70,000 along with a performance bonus of $7,000. Besides, he also earned dividend income of $6,500 from stock investment and interest income of $5,000 from bank deposits. Determine the U.I earned by Jimmy during 2019.
Firstly, it is important to identify the sources of 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 are sources of U.I.
- Given, Interest income = $5,000
- Dividendincome = $6,500
U.I is calculated 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 during the year 2019.
Types of Unearned Income
Although there are several sources through which U.I can be generated, some of the common 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 (VA)
- 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
The unearned income that 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 in the journal entry.
Some of the major advantages of unearned income are as follows:
- In the case of unemployment, U.I serves as the sole source of income.
- In some cases, U.I can be used to defer tax payments as well as avoid penalties from the Internal Revenue Service (IRS).
- The U.I serves as the passive source of income as it generates steady cash flow over a period of time in exchange for little to no additional effort.
Some of the major 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 of time.
- The tax rules for U.I can be very complicated in some cases.
So, it can be seen that U.I is a very important source of passive income for individuals as it ensures steady cash inflow in the long run and helps in wealth accumulation. 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.
This is a guide to Unearned Income. Here we also discuss the introduction and types of unearned income along with its advantages and disadvantages. You may also have a look at the following articles to learn more –