According to IRS the definition “unearned income is the income earned from various sources without indulging in that work which means not being physically present or not putting any efforts on the production”.
IRS considers salaries, wages, tips, bonuses, and other taxable into earned income, and those which don’t come under these criteria fall under unearned income.
For unearned income, the taxation process will differ from earned income. Most unearned income sources are not subject to payrolls. Unearned incomes are also not subject to employment taxes like social security and Medicare security and some unearned income are not taxed at all like life insurance.
Some Types of Unearned Income?
- Assistance Payments like TAFDC, EAEDC, or other assistance programs
- Pensions or retirement benefits
- Annuities
- Veterans’ benefits
- Disability benefits
- Workers compensation
- Unemployment Compensation
Example:
Suppose an individual got retired from a government job and again he started a new career in a firm where he gets an amount of $80000 per year and a bonus of $10000. So, the total earned income will be $90000 per year.
Now the same person gets dividend stocks and also pension from the government. The amount he gets from dividend stocks is $500 per month and he gets $2000 per month as a pension. Therefore, the total unearned amount will be the addition of both the figure and then multiply that by 12 months which is $2500 x 12 is $30000.
Why Unearned Income Matters?
Unearned income matters for an individual because unearned income increases the economic level of that individual. By the unearned income, an individual can invest in various things which will help him in making more money. Every individual should have an extra source of income to meet their expenses.
Unearned Revenue with Accrual Vs Cash Accounting: –
Any business that accumulates unearned income should record it accordingly. First, it is important to have resources planned for the future of a product and service delivery. If it was not them, a business or the person may be selling something they can’t support or deliver.
Also, the United States Securities and Exchange Commission (SEC) has to report the requirements for businesses that are specific to revenue recognition. Revenue recognition is a generally accepted accounting principle (GAAP) that tells how revenue is accounted for. According to GAAP, unearned revenue is acknowledged over time as the product or service is delivered, based on specific critical events.
The SEC has set a criterion for how revenue is organized. Thanks to the recent takeover of Accounting Standards ASC 606, revenue recognition rules are now more systematic.
When Is Unearned Revenue Recognized?
Let’s say a salon pays upfront for custom web development to build out the grooming cart on their website. The web development company receives a $10,000 payment upfront.
For each accounting period, the web development company will look at what they are contractually obligated to do for the salon, what they really did during that period, and then calculate how much of the total of $10,000 it represents.
Let us consider they were obligated to and performed three-quarters of the total contract in a 90-day accounting period. The web development company would then recognize $7,500 in revenue for that period.
At that point, the unearned revenue amount of current liabilities would reduce by $7,500, and the cash could then be listed as a current asset instead of using an adjusting journal entry.
Tax differences:
There is a difference between taxes applicable to earned income and unearned income because of their unique income classification.
Taxes on Earned Income:
An individual pays two primary taxes which are federal and states taxes and the other is social security and Medicare taxes for an earned income mainly know as payroll taxes.
The government has a standard formula for determining how much an individual needs to pay for their earned income toward social security and Medicare taxes. For a normal person who works for a firm or a company, 12.4% is deducted from his or her payroll. An individual pays 6.2% and the employer pays the other half.
And if you are self-employed then you have 12.4% entirely yourself.
Taxes on Unearned Income:
Unearned income isn’t subject to payroll taxes like earned income. This is a benefit of unearned income. But you do have to pay taxes for unearned income. In some cases, such as stock dividends and capital gain the amount of tax is at lower rates. Unearned income is taxed under the category of Adjusted gross income or AGI in IRS guidelines.
Conclusion:
Earning from a source where you do not have to invest your time, you do not have to be physically present there, and then getting a return from them is certainly a goal for everyone. Therefore, unearned income is a great source of doing this. But you need to be very sure about where you are investing. Again, check the latest guidelines on the IRS website.