What Is Unearned Income? A Guide for Expats

Americans living abroad are required to report their worldwide income to the IRS every year. Not all forms of income are taxed equally, however, and the most important distinction is earned vs. unearned income. But what is unearned income—and how does it fit into your expat taxes? Let’s take a look.

What Is Earned Income?

Typically, earned income means receiving compensation for a service you’ve provided. Common types of earned income include:

  • Wages
  • Salaries
  • Bonuses
  • Tips
  • Commissions
  • Vacation pay
  • Sick leave
  • Severance pay
  • Union strike benefits
  • Disability benefits
  • Self-employment income

What Is Unearned Income?

While earned income generally means compensation for a service, unearned income means generating profits without really doing anything. Common types of unearned income include:

  • Interest
  • Dividends
  • Pension payments
  • Rental income
  • Capital gains
  • Annuity payments
  • Royalties
  • Alimony
  • Awards
  • Unemployment benefits
  • Taxable Social Security benefits
  • Gambling winnings
  • Debt relief
  • Distributions from trusts or retirement accounts

If you’re still not clear on the difference between earned and unearned income, here are some examples.

Earned Income vs. Unearned Income Example 1

Jacquelyn earns $70,000 per year as a freelance web developer. She also rents out her apartment for $1,500 per month ($18,000 per year) and operates an online share portfolio that brings in $500 per year.

Jacquelyn’s self-employment income is earned income, while her rent and portfolio profits are unearned income. That means she would report:

  • $70,000 in earned income
  • $18,500 in unearned income

Earned Income vs. Unearned Income Example 2

Zach works as a bartender, making $8,750 a year in wages. Most of his annual income comes from tips, however, which add up to $26,250. Zach also plays professional poker on the side, making about $12,000 for the year.

Zach’s wages and tips are earned income, while his poker winnings are unearned income. This comes out to:

  • $35,000 in earned income
  • $12,000 in unearned income

Earned Income vs. Unearned Income Example 3

Alejandro is between jobs for the year. He does have some sources of income, though. Because of the money in his savings account, he gets $105 in interest. He also receives $2,500 in unemployment benefits and $10,000 in capital gains due to selling his house.

All of Alejandro’s income is unearned income, totaling $12,605 for the year.

Earned Income vs. Unearned Income Example 4

Amelia is a semi-retired teacher who receives a $25,000 pension. Now, she works as a tax preparer, bringing in another $30,000 per year. On top of this, she’s also a savvy investor, making about $6,000 in dividends.

Amelia’s income as a tax preparer is earned, while her pension and dividends are unearned. This means she makes:

  • $30,000 in earned income
  • $31,000 in unearned income

Is Foreign Unearned Income Taxable?

Yes. When expats file their US Federal Tax Returns each year, they are required to report all of their worldwide income, including both earned and unearned income. Like earned income, you’ll include your unearned income in your Adjusted Gross Income (AGI) on your tax return.

How Is Unearned Income Taxed?

For the most part, unearned income is taxed the same as earned income. However, there are some key differences worth noting.

To start with, unearned income is not subject to Social Security or Medicare payroll taxes as earned income is. (Though earned income may also be exempt from these taxes if the US has entered into a Totalization Agreement with the country you reside in.)

Beyond this, when it comes to long-term capital gains and dividends, the unearned income tax rate can drop significantly depending on your tax bracket and filing status. In some cases, this could mean major savings.

It isn’t all good news, though. Unfortunately, you can’t use unearned income to contribute to your IRA. That means that if you live exclusively on unearned income—such as unemployment benefits or a trust fund—you’ll have to find an alternate method to stow away funds for your retirement.

How Can I Reduce My Expat Tax Liability for Unearned Income?

There are a few potential ways for an expat to reduce their US tax liability on unearned income. The most common is the Foreign Tax Credit. This credit helps Americans living abroad avoid double taxation.

For example, if you live in Portugal and pay a tax to the Portuguese government for the income you’ve earned within their borders, you’ll have to report that same income to the IRS—since US tax law requires all citizens to report their worldwide income.

This could lead to double taxation, meaning that you pay taxes twice on the same income, once to Portugal and once to the US.

To keep this from happening, the IRS lets expats use Form 1116 to claim a Foreign Tax Credit. Then, the IRS will forgive your tax debt for any income you’ve already paid a tax on to a foreign government. In many cases, this will reduce your US tax bill to zero—which is why so few expats end up paying US taxes at all.

Best of all, you can claim the Foreign Tax Credit for both earned and unearned income. So if you’re already paying taxes to your country of residence for your interest, capital gains, pension, or other unearned income, you won’t have to worry about paying Uncle Sam too. (Though you’ll still need to report your entire income.)

And while the Foreign Tax Credit is nonrefundable, you can carry any excess credit over for future years, further decreasing your chances of owing the IRS.

Another potential method for easing the tax burden on your unearned income is through a tax treaty. The US has established treaties with numerous foreign nations to help offer tax benefits for Americans living abroad.

If you live in a country that has entered into a tax treaty with the US, you may be able to lower the tax obligations that would typically be associated with your unearned income.

But while the Foreign Tax Credit or a tax treaty may help you shrink—or erase—your tax bill, the Foreign Earned Income Exclusion (FEIE) cannot be used to exclude unearned income as it can for earned income.

Get Expert Assistance With Your Expat Taxes

In this post, we’ve gone over the basics of how unearned income will factor into your expat taxes. But US tax law is always complex, especially for Americans living abroad. It can be difficult to know exactly what you need to report or what you owe.

This can lead to either accidentally shirking your tax obligations or paying more than you need to.

So if you have any questions—even if it’s still “What is unearned income?”—just contact us, and we’ll be happy to give you the answers you need. Or, if you’d like some professional assistance with your expat tax strategy, we can do that too.

At Greenback Expat Tax Services, we’ve spent years helping expats file their taxes accurately, on time, and without a dollar wasted. We’d love to help you too.

Click here to get started on your expat taxes today.