Unearned Income: Meaning, Types, Taxability & Journal Entry

In the past decade, financial awareness, retirement planning and additional sources of income has gained more popularity among general masses. Here is where the concept of unearned income becomes important to appreciate for attaining financial goals. Income that is earned without significant efforts could be termed as unearend income. Let us understand the meaning, importance, example, accounting treatment and tax implications of unearned income through this article. 

What is Unearned Income?

• A person's income can be classified in numerous ways, starting with its sources, the nation in which it arises, its legality (yes! Even illegal income is subject to Income Tax in India), its status (received or pending receipt), and so on. 
• Another means of classification could be whether significant efforts have been made to earn income or not.
• Income earned without exerting significant efforts could be classified as unearned income.
• Unearned income, as far as income tax is concerned, does not have special treatment in income tax just because of its nature - earned without significant effort.

Why Unearned Income?

• As the importance of financial health, stability, and planning continues to grow, and excessive spending and show-off become less fashionable, the concept of generating passive income using savings is a highly sought-after form of wealth-building.
• More people recognize the value of securing long-term financial independence and freedom without relying on active work.

Types of Unearned Income

Just like there are many ways to classify income, there are quite possible classifications that could be made for unearned income. Read more to understand significant types of unearned income and tax saving options for each type of income.

Interest Income

• This is the most favorite form of unearned income is interest income. 
• As we all know, interest is a periodic payment, usually a certain percentage of the amount deposited for a certain period of time.
• Though it is of passive nature, interest income is also subject to Income Tax in India. It is treated under the head ‘Income from Other Sources’.

Tax Saving Options

• Section 80TTA: This deduction can be claimed for any interest received from a savings bank account. A maximum deduction of Rs.10,000 can be claimed.
• Section 80TTB: Deduction under section 80TTB can be claimed only by senior citizens. This deduction can be claimed for interest from both savings accounts and deposits. A maximum deduction of Rs.50,000 can be claimed.

Both of the aforesaid deductions cannot be claimed under the new regime.

Rental Income

• Broadly speaking, rental income accrues from giving off the right to use a certain asset for a certain period of time. 
• Rental income could be from real estate properties, movable assets like cars and furniture, or intangibles like intellectual properties. 
• It is usually perceived that rental income does not involve significant effort. However, it is very much possible that renting assets is a primary business activity of a taxpayer. 
• For example, rent obtained from a wedding hall is a purely commercial activity; income earned from the same should be classified as business income. Whereas rent from a house or a shop for rent should be classified as income from house property.
• If a movable asset is rented, such as furniture, and it does not involve a significant effort to make income, it could be classified as income from other sources. 

So, rental income could be classified as business income, house property income, or income from other sources, depending on the nature of the activity and the asset involved.

Tax Saving Options

• If the rental income is income from house property: 
  • 30% standard deduction is available for all house property income.
  • Interest paid on a loan acquired for construction or purchase can be claimed as a deduction
  • Principal repayment can also be claimed as a deduction under section 80C. 
• If the rental income is business income:
  • Expenses incurred related to that business can be claimed as a deduction.
• If the rental income is income from other sources: 
  • Generally, the deduction can be claimed for any expenses that are incurred for attaining the income, except under exceptional circumstances.

Dividend Income

• Dividend is a portion of profits earned by the company paid to a share holder. It is the consideration given to a shareholder for investing in the shares of the company.
• Mostly, dividends is taxable under the head income from other sources.

Tax Saving Options

Interest paid for money borrowed used to purchase shares, can be claimed as a deduction against dividend income. A maximum of 20% of dividend income can be claimed as an interest deduction.

Pension

• Money received regularly after the person has stopped working could be termed as a pension.
• Pension is mostly received after retirement, it could also be received on the death of the employee.
• Just like we saw rental income can be classified basis the nature of the activity, pension can also be classified either under the head salary or income from other sources.

Tax Saving Options

• Pension received by family members on the death of a defence personnel in service is fully exempt.
• If a person (not in the defence forces) dies, the pension received by their family is taxable., one-third of income could be exempt. Under the old regime, a maximum of Rs. 15,000 could be claimed as a deduction. If a new regime is opted, a Rs. 25,000 deduction is allowed instead of Rs. 15,000.

Capital Gains

• Capital Gains arise from the sale of capital assets such as properties, shares, jewelry, etc.
• Under Income Tax Act, such income is taxable under a specific head, ‘capital gains.’ 
• Tax treatment, including tax rates, is determined based on the nature of assets held and the duration for which assets were held.

Tax Saving Options

• Long Term Capital Gains of specified assets up to Rs.1,25,000 is exempt.
• Long Term Capital Gains have many exemption options under section 54 series.

Casual Income

• Ever been lucky enough to win a lottery or gamble? Prepare to share your luck with the government. Your winnings are subject to a tax of a flat 30%
• Casual Income includes income earned from a game show, lottery, betting, gambling, online gaming, etc.,
• It is to be noted that there are hardly savings options for casual income. All income is subject to 30% tax.

Scholarship

• As scholarship does not involve significant efforts to earn, it is unearned income.
• In fact, under section 10(16) of the Income Tax Act, scholarship received for educational purposes are completely exempt from tax. 

How much Unearned Income Requires Filing Taxes?

• As discussed at the beginning of this article, the tax treatment of unearned income differs depending on how income is earned, and the classification of that income under the Income Tax Act.
• Generally speaking, when the income crosses the slab rates, a return of income needs to be filed. 
• There are certain incomes that are taxed at special rates. For those income, irrespective of the amount of income earned, returns need to be filed. For example, capital gains and casual income.

Unearned Income and Accrued Income

Though accrued income and unearned income are entirely different concepts, they are often misunderstood synonymously.

• Income that is earned and yet to be received is called accrued income. However, income that does not require significant effort is called unearned income.
• Because of the nature of accrued income (which is not yet received), it is perceived as unearned income, which is not appropriate.
• Though accrued income has not yet been received, it has already been earned. This perception is correct from both accounting and income tax standpoints.

Illustration

An example of accrued income would be salary earned for a particular month but not yet received. In this example, significant efforts are involved in earning the money. Therefore, just because it is not yet received, it cannot be termed as unearned. In fact, it is already earned as soon as the person works.

Journal Entry for Unearned Income

We can consider the previous example of a Rs. 1 lakh gift received from a relative. Since the asset (cash) is received, it is debited in the books. Since the nature of the receipt is income, the Unearned Income account is credited in the books. The following is the journal entry for this transaction.

Final Word

It is necessary for money to work for us rather than us to keep working for money. Smart wealth building definitely brings peace to your life, whereas smart tax planning for that income will only help you reach your financial goals faster!