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Andrew Henderson

Founder of Nomad Capitalist and the world’s most sought-after expert on global citizenship.

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Finance

A Guide to Unearned Income and How It’s Taxed

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Passive income is great, right?

A ‘fire and forget’ financial missile that, once set up, will supply you with an endless supply of money without requiring you to do anything: other than simply enjoy it.

Well, it doesn’t quite work that way but, then, nothing ever does.

The concept of not having to work for the passive income you earn is a somewhat misguided view of the effort required in building a diverse portfolio of investments. 

Endless hours spent studying share prices and company fundamentals, property markets and crypto, as well as discerning the full range of profitable and not so profitable opportunities, can’t be dismissed as anything other than hard graft.

Even when investments are being managed by an external party, you’ll never be able to shake the sense that being aware of the ebb and flow of markets and their latest developments is always necessary. 

Passive Income versus Earned Income

In purely tax terms, however, unearned income is that which is not earned from work. Unearned income comes from sources where you have not performed services. Some examples include income from interest and dividends from investments, retirement income, social security and unemployment benefits, spousal maintenance or alimony and child support. The term can also be used to describe inheritance money and any form of financial prize or gift of money. 

In contrast, you receive earned income by working for someone who pays you, or by owning or running a business.

Some examples of earned income include wages, tips and other taxable pay; it can also be a year-end bonus or a sales commission, for example. Earned income status also applies to long-term disability benefits received before reaching the minimum retirement age. Past the minimum retirement age, disability income is usually defined as unearned. 

There’s also self-employment income and that earned by a statutory employee – an independent contractor with working conditions that permit them to be treated as an employee for tax purposes. 

On the other hand, royalties from intellectual property such as patents, books or music and gains from the sale of investments or real estate are also classified as unearned income.

Then there’s rental income. Let’s suppose an investor has two rental properties that supplement their regular income. This is considered a passive investment and as such it is unearned income that’s taxed at the marginal income tax rate.

Passive income generally includes net income received from a rental property and distributions from a REIT or real estate partnership. An exception to this rule would be when an investor works in real estate full-time, where tax rules become complicated and taking advice is recommended. 

Passive Income versus Earned Income

Unearned Income and Taxation

In the United States (US), the Internal Revenue Service (IRS) separates all income into earned and unearned categories. So why is this distinction important? The IRS calculates two refundable tax credits, the earned income credit and the additional child tax credit on your total earned income. 

The standard deduction for taxpayers who are dependents of other taxpayers is based on how much earned and unearned income the dependent taxpayer has. 

For 2024, unearned income above US$2,600 may be subject to an unearned income tax, known as the kiddie tax. Alternatively, interest and dividend income of less than US$13,000 for 2024 can be included on the parent’s return rather than that of the child. 

Unearned income is generally treated as taxable income, so even when it’s earned passively, it still has to be reported on your tax return. However, most unearned income is not subject to payroll, social Security and medicare taxes. 

Retirement payments such as those from Individual Retirement Accounts, pensions, or other retirement plans, must be included on your tax return.

Unearned Income vs Earned Income

The topic is important because earned income and unearned income receive different tax treatments, and you can significantly improve your tax planning strategy by understanding it. 

Earned income is taxed at ordinary tax brackets, whereas the tax rules for unearned income are different. Most investment income gets taxed at a rate that is lower than the ordinary income tax rate if the investment is considered long-term.

For an investment to be considered long-term, the asset must be held for at least a year and a day. For long-term investments, most people pay 15%, while higher earners will pay 20%. Short-term capital gains are taxed at ordinary income tax rates that range from 10% to 37% in the US and 20% to 40% in the United Kingdom (UK).

Some unearned income, like qualified dividends and long-term capital gains, are taxed at lower rates. Some unearned income is not taxed at all, for example, life insurance proceeds when the insured person dies.

Understanding how specific forms of unearned income get taxed can be complicated and impact your overall tax liability. Getting professional tax advice to ensure you are optimising your investment taxes is recommended.

The distinction between earned and unearned income in terms of taxation has become a topic of debate in the UK recently. In recent years, calls for the equalisation of capital and employment tax rates have grown.

A Savanta ComRes poll for 38 Degrees found that 61% of the UK public support an increase in capital gains tax so that it’s on par with income tax. 

A study by the Intergenerational Foundation think tank concluded that earned income is taxed twice as heavily as capital gains for some in the UK. The findings emphasised a gap between those who receive more income from property and shares, often older people and those who depend on income from employment.

For example, someone receiving GBP£60,000 a year in the form of capital gains or dividends pays less tax, the study found, than someone earning GBP£35,000 from a job. 

Whether you agree with calls for tax equalisation or not, it’s clear that unearned income plays an important role in wealth-building for those who have income from investments. 

In particular, it’s a critical component of retirement planning that offers an income stream that’s not dependent on employment. The more assets you have generating unearned income, the less you rely on employment to meet your financial goals.

Unearned Income vs Earned Income

Protecting Your Income and Investments

Whether you’re a US, UK, Canadian or Australian citizen – or one of any other developed Western economy – the simple truth is you’re going to pay considerable tax on all your income.

Whether it’s earned or unearned, your income in these countries is subject to higher tax. The rationale for this, according to the powers that be, is often linked to the benefits you receive in exchange for citizenship.

As a tax resident of a legacy country, as we call them at Nomad Capitalist, you are essentially bound by tax laws that limit the financial rewards of your endeavour. 

Many high-net-worth individuals have a diverse portfolio of investments which could include companies, real estate, shares and even crypto assets. Some of that income could be made overseas and still be taxed at exorbitant rates in your home country – but that doesn’t have to be the case. What, or even whether, you need to pay will depends on whether you’re classed as tax resident. If you’re not a resident, you don’t have to pay tax on your foreign income.

Getting out from under your own country’s tax system and establishing a low-tax base somewhere else, can lower your tax burden and protect your assets better for you, your family, and future generations to enjoy more.

It is what we call ‘going where you are treated best’ and it looks different for each of the 1500+ high-net-worth people we work with. 

From getting citizenship in any one of a number of low and no-tax jurisdictions with a second passport, to tax-efficient overseas company formation and asset protection, we create and implement bespoke, holistic strategies for successful investors and entrepreneurs.

This is about maximising your freedoms, with the ideal mix of location, lifestyle, tax planning and asset protection strategies working in combination to achieve your goals.

Rest assured, our global team of over 60 professionals and country-specific advisors leave no stone unturned when it comes to helping you build a fortress to protect your assets. This is all about legally reducing your tax rate and legally reducing while living your desired lifestyle: maximum freedom with minimum tax.

You will need to plan this carefully, however and that’s where Nomad Capitalist comes in. 

We help seven- and eight-figure entrepreneurs and investors create a bespoke strategy using our uniquely successful methods. We’ll help you keep more of your own money, create new wealth faster and be protected from whatever happens in just three steps. Become a client today.

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