Unearned income is an important part of a well-rounded financial plan, especially as retirement approaches. By understanding how it is taxed and implementing smart strategies, you can reduce your tax burden and make your money work harder for you.

Why it Matters

Unearned income can supplement earned income during working years and often becomes the primary source of funds in retirement. How it’s taxed can have a significant impact on your net income, making strategic planning essential. By implementing proactive strategies, you can reduce taxes, optimize retirement savings, and preserve more wealth for the future.

What is unearned income and how is it taxed?

Unearned income is money you earn passively, without performing work or providing services. Unlike earned income, such as wages, salaries, or self-employment income, unearned income comes from investments or other sources. Common examples include interest, dividends, rental income,  and lottery winnings. 

• Interest: Earned from savings accounts, CDs, bonds, and loans; generally taxed as ordinary income, except for some municipal bonds.
• Dividends: Can be ordinary (taxed at standard rates) or qualified (taxed at favorable capital gains rates).
• Other sources: 401(k)s, pensions, annuities,  Social Security, veterans’ benefits, unemployment, and rental income.

Unearned income is generally taxable, but usually not subject to payroll taxes like Social Security and Medicare.

Strategies to Reduce Taxes on Unearned Income

1. Maximize Tax-Advantaged Accounts- Invest through IRAs, 401(k)s, or Roth accounts where earnings grow tax-deferred or tax-free. Contributions to traditional retirement accounts can reduce taxable income today, while Roth accounts allow for tax-free withdrawals in retirement.

2. Invest in Tax-Exempt or Tax-Preferred Securities- Municipal bonds and certain government-backed securities can provide interest income that is federally tax-free. Additionally, holding investments long enough to qualify for long-term capital gains or qualified dividends reduces tax rates.

3. Harvest Investment Losses- Offset capital gains by strategically selling underperforming investments. This process, called tax-loss harvesting, can reduce your taxable unearned income and potentially lower your tax bill.

4. Consider Timing of Withdrawals- Planning when to take distributions from retirement accounts, pensions, or annuities can minimize taxes. For example, spreading withdrawals over multiple years may keep you in a lower tax bracket.

5. Diversify Income Sources- A mix of taxable, tax-deferred, and tax-exempt investments can help smooth tax burdens and reduce the impact of high-income years.

Are there any One Big Beautiful Bill Act (OBBBA) impacts that impact this?

Yes. The OBBBA includes provisions that can influence unearned income planning:

• Expanded Employer Credits: Businesses that contribute to retirement accounts or offer paid leave may benefit from higher tax credits, indirectly affecting retirement savings and taxable income.
• QBI Deduction Changes: The phase-in thresholds for pass-through owners expand in 2026, which may impact owners who also receive unearned income from investments or business distributions.
• Tax-Deferred and Retirement Accounts: With the OBBBA, certain provisions affecting 401(k)s and retirement distributions could interact with your unearned income planning, giving more flexibility for tax timing strategies.