For U.S. citizens living abroad, understanding your filing obligations to the Internal Revenue Service (IRS) can be overwhelming. One of the most misunderstood aspects of filing a U.S. tax return from overseas involves unearned income. Whether you earn income through foreign bank accounts, investment income, rental income, or pension payments, the IRS may require you to report it. This guide explains what qualifies as unearned income, how the unearned income tax applies, and how expats can stay compliant.
What Is Unearned Income?
Unearned income refers to income that is not derived from active employment or services. It includes income sources such as:
Interest income from savings accounts or bonds
Dividend income and qualified dividends from stocks
Capital gains (including short term capital gains and long term capital gains)
Rental income from real estate
Social security benefits (in some cases)
Pension payments and annuity payments
Unemployment compensation
Gambling winnings
Passive income like royalties or limited partnership earnings
These unearned income sources are typically taxed differently from earned income, which comes from wages, salaries, or self-employment.
Earned vs. Unearned Income: Key Differences
The IRS categorizes income into earned income and unearned income. This distinction matters because the tax treatment and tax implications vary significantly:
Earned income is subject to payroll taxes (including social security and medicare taxes) and includes wages, self employment income, and bonuses.
Unearned income, unlike earned income, is not subject to employment taxes but can still affect your overall tax liability and eligibility for tax benefits like the earned income tax credit.
Understanding these key differences is vital for effective tax planning and compliance.
Do You Have to Pay Taxes on Unearned Income?
Yes. U.S. expats are generally required to pay taxes on worldwide income, including unearned income. Whether you live in France, Japan, or Brazil, the IRS still expects a tax return if your unearned income exceeds specific thresholds.
Income tax on unearned income is usually based on your ordinary income tax bracket. However, some types of unearned income—such as qualified dividends or long term capital gains—may be taxed at lower, preferential tax rates.
Additionally, high-income earners may face the net investment income tax (NIIT), a 3.8% surtax on investment income like dividends, capital gains, and rental income.
Examples of What Is Considered Unearned Income
Let’s take a closer look at common income types considered unearned income by the IRS:
Interest and dividends from foreign or domestic bank accounts
Rental income from property you own but do not manage actively
Capital gains from selling property, stocks, or other investments
Annuity payments and pension payments received after retirement
Social security benefits (fully or partially taxable depending on your adjusted gross income)
Unemployment benefits
Gambling winnings and lottery prizes
If you receive cash payments for any of these without performing labor or services, it’s likely considered unearned income.
Unearned Income and Children
Even a minor child may have a filing obligation if they earn more than a certain amount in child’s unearned income. As of recent tax years, the threshold is $1,250 for a child with only unearned income. Above that, a tax return must be filed, and the tax liability may be calculated at the parents’ tax rate under the “kiddie tax” rules.
Tax Rates and Unearned Income
The income tax you owe on unearned income depends on:
Your total income
The income type (e.g., ordinary dividends taxed at ordinary income rates vs. qualified dividends at reduced tax rates)
Whether you’re subject to the net investment income tax
Here are general tax treatment guidelines:
Ordinary income: Taxed at your standard rate
Qualified dividends: 0%, 15%, or 20%, depending on taxable income
Long term capital gains: Usually 15% or 20%, depending on your bracket
Payroll Taxes and Unearned Income
Unlike self employment income or self employment earnings, unearned income is not subject to payroll taxes. This means you don’t pay social security and medicare taxes on it. However, this also means it doesn’t count toward social security benefits eligibility or increase your retirement savings like contributions to retirement accounts might.
Do State Income Taxes Apply?
While living abroad, many expats are no longer liable for state income taxes if they sever ties with their previous state. However, some states like California and New Mexico aggressively pursue former residents. If you still have bank accounts, property, or a driver’s license in those states, consult a financial advisor for personalized tax planning strategies.
Minimizing Tax Liability on Unearned Income
Here are a few strategies to consider:
Use foreign tax credits and the Foreign Earned Income Exclusion (FEIE) where applicable (though FEIE applies only to earned income)
Invest in retirement accounts that offer deferred taxation
Time the sale of assets to take advantage of favorable long term capital gains treatment
Track and report expenses against rental income
Consult a financial advisor for cross-border tax planning
These steps can reduce your overall tax liability and help optimize your financial security.
Making Estimated Tax Payments
If your unearned income is substantial and no tax is withheld (as with many foreign bank accounts or investments), you may need to make estimated tax payments quarterly to avoid penalties.
Do You Have to File If You Only Have Unearned Income?
Yes, if your unearned income exceeds the filing threshold. For single filers under 65, the threshold is generally $1,250 (2024). So even modest dividend income or savings account interest could trigger a filing obligation.
1040 Abroad is here to help
Navigating the rules around unearned income tax is a crucial part of staying compliant with the internal revenue service as a U.S. expat. From rental income to capital gains and social security, knowing what’s considered unearned income helps you understand your tax liability and plan effectively. Unlike those with earned income, you may not pay payroll taxes, but the federal income tax still applies.
Understanding your income type, reporting it accurately, and using smart tax planning strategies will help minimize your burden and maximize your tax benefits.
If you’re unsure about your situation, 1040 Abroad can help you prepare your tax return accurately and ensure you comply with IRS requirements. Get in touch today to secure your peace of mind.
