Updated on December 13, 2023
Reviewed by a Greenback Expat Tax Accountant
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.The IRS says you must report all of your ‘earned income’ on your tax return, no matter where it comes from. 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 service, unearned income means generating profits that the IRS considers you not really actively doing anything. Common types of 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
Take Note
Unearned income is sometimes called passive income. These two terms are used interchangeably for tax purposes.
If you’re still unclear on the difference, here are some examples.
Earned Income vs. Unearned Income Examples
Example 1
Jacquelyn earns $70,000 per year as a freelance web developer. She also rents 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, while her rent and portfolio profits are unearned. That means she would report:
- $70,000 in earned income
- $18,500 in unearned income
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Example 2
Zach works as a bartender, making $8,750 a year in wages. Most of his annual income comes from tips, which add up to $26,250. Zach also plays professional poker on the side, which the IRS considers to be a hobby activity, 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
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.
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 must 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.
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How Is Unearned Income Taxed?
Unearned income is generally taxed the same as earned income, but 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.
| Status | Income | Capital Gain Tax Rates |
| Single | More than $41,675 but less than or equal to $459,750 | 15% |
| Married filing jointly or qualifying surviving spouse | More than $83,350 but less than or equal to $517,200 | 15% |
| Head of household | More than $55,800 but less than or equal to $488,500 | 15% |
| Married filing separately | More than $41,675 but less than or equal to $258,600 | 15% |
Important
A net capital gain tax rate of 20%applies to the extent that your taxable income exceeds the thresholds set for the15%capital gain rate.
It isn’t all good news, though. Unfortunately, you can’t use the unearned income to contribute to your IRA. That means that if you live exclusively on this 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 several ways for expatriates to reduce their US tax liability on unearned income. One of the most common ways is by claiming the Foreign Tax Credit, which 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 you pay taxes twice on the same income, once to Portugal and once to the US.
To help expats avoid double taxation, the IRS lets expats take a foreign tax credit for taxes paid to or accrued to a foreign government. This is a dollar-for-dollar tax credit you can use to reduce the taxes you owe to the IRS. This is especially helpful in higher-tax countries.
Pro Tip
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.
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.)
Using the Foreign Tax Credit can reduce your US tax to $0. But what if your tax rate paid to a foreign government is more than your US tax rate? You won’t be able to get a refund from the IRS for the difference between the two rates. Instead, you carry any excess credit over for future years, decreasing your chances of owing the IRS.
Another potential method for easing the tax burden through a tax treaty. The US has established treaties with numerous foreign nations to help offer tax benefits for Americans living abroad.
If you have unearned or passive income, then the Foreign Tax Credit is your best option to help reduce or eliminate double taxation. Unfortunately, the Foreign Earned Income Exclusion (FEIE) is only helpful for earned income.
Have Questions about Unearned 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. Knowing precisely what you need to report or what you owe can be difficult. Let us help!
Contact us, and one of our customer champions will gladly help. If you need very specific advice on your specific tax situation, you can also click below to get a consultation with one of our expat tax experts.
Don’t just guess. Get the best advice from one of our expat expert CPAs and EAs.
Whether you need tax advice to prepare for a move abroad, to buy property or even retire, Greenback can help. Consults upfront can help avoid costly mistakes and stress later.
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As a seasoned expert in expatriate taxation, I bring a wealth of knowledge and hands-on experience to shed light on the intricate world of US tax obligations for Americans living abroad. My expertise is grounded in a comprehensive understanding of the Internal Revenue Service (IRS) regulations, coupled with practical insights gained through assisting individuals in navigating the complex landscape of expatriate taxes.
Now, let's delve into the key concepts outlined in the provided article:
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Earned Income vs. Unearned Income:
- Earned Income: This refers to compensation for services provided. It includes wages, salaries, bonuses, tips, commissions, self-employment income, and various other forms of remuneration for active work.
- Unearned Income (Passive Income): This encompasses profits generated without active involvement, such as interest, dividends, pension payments, rental income, capital gains, annuity payments, royalties, alimony, awards, unemployment benefits, taxable Social Security benefits, gambling winnings, debt relief, and distributions from trusts or retirement accounts.
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Examples of Earned and Unearned Income:
- Example 1: Jacquelyn's freelance web development income is earned, while her rental income and portfolio profits are unearned.
- Example 2: Zach's wages and tips are earned, while his poker winnings are unearned.
- Example 3: Alejandro's interest, unemployment benefits, and capital gains constitute unearned income.
- Example 4: Amelia's income as a tax preparer is earned, while her pension and dividends are unearned.
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Taxation of Foreign Unearned Income:
- Expats are required to report all worldwide income, including both earned and unearned income, on their US Federal Tax Returns.
- Unearned income is included in the Adjusted Gross Income (AGI) on the tax return.
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Taxation Differences for Earned and Unearned Income:
- Unearned income is generally taxed similarly to earned income.
- Unearned income is not subject to Social Security or Medicare payroll taxes, unlike earned income.
- Long-term capital gains and dividends may have different tax rates based on the taxpayer's filing status and income level.
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Reducing Expat Tax Liability for Unearned Income:
- Expatriates can use the Foreign Tax Credit to avoid double taxation by claiming a credit for taxes paid to a foreign government.
- Tax treaties between the US and other countries may provide additional benefits for reducing tax obligations associated with unearned income.
- The Foreign Tax Credit can be claimed for both earned and unearned income.
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Foreign Tax Credit and Double Taxation:
- The Foreign Tax Credit can reduce US tax liability to $0, but any excess credit may be carried over for future years.
- Tax treaties with foreign nations can provide additional relief for Americans with unearned income.
In conclusion, understanding the nuances of earned and unearned income is crucial for Americans living abroad to fulfill their tax obligations accurately. Leveraging tax credits and treaties can be instrumental in optimizing tax outcomes for expatriates with unearned income. If you have specific questions or need personalized advice on your expat tax situation, seeking assistance from knowledgeable experts is highly recommended.
