What is 'Earned Income'

The term earned income may seem simple enough to define, but not knowing the specifics can lead to taxing consequences.

The obvious types include wages, salaries, bonuses, commissions, tips and net earnings from self-employment. The not-so-obvious items involve long-term disability and union strike benefits; and in some cases, even payments from certain deferred retirement compensation via 401ks, pensions and stock-option plans.

Examples of what isn’t considered earned income and, therefore, non-taxable, include welfare, unemployment, worker’s compensation and social security benefits, disbursements from non-deferred pensions and retirement plans, alimony, capital gains, interest income, stock dividends and bond interest, and passive income generated from rental property.

Understanding Tax Implications

It’s important to understand the distinction between earned and non-earned income for filing your taxes, especially for people opting to receive early Social Security checks and those who are self-employed.

The IRS limits the amount of earned income you can have while collecting federal retirement benefits. Exceeding that amount could result in owing back some of that money. Interestingly, you also cannot make contributions to any IRA without earned income.

If you work for a company, payroll automatically deducts Social Security/Medicare taxes and federal and state taxes. However, if you’re self-employed, you’ll need to determine that amount and either pay quarterly estimated taxes or a lump sum by Tax Day in April. If you are self-employed and have employees you are legally responsible, according to the IRS, to notify each one who has worked for you at any time during the year and from whose wages you did not withhold income tax. However, if someone claimed exemption from withholding on their W-4 form, that person does not have to be notified.

Are You Missing Out?

While the IRS takes away in the form of taxes, it also provides a tax credit on earned income. Your marital status, number of children and amount of earned income determine the size of the credit. Find out if you’re eligible at www.IRS.gov/eitc.

According to the IRS, many people qualify but miss out on the credit. The IRS website lists the following workers most at risk for not claiming the credit on their taxes. They include those:

  • Living in non-traditional homes, such as a grandparent raising a grandchild

  • Whose earnings declined or whose marital or parental status changed

  • Without children

  • With limited English skills

  • Veterans

  • Living in rural areas

  • Who are Native Americans

  • With earnings below the filing requirement

  • Who have disabilities or are raising children with disabilities

If you're unsure whether you qualify or have questions about your specific situation, be sure to seek advice from a tax expert.

BREAKING DOWN 'Earned Income'

Earned income includes any income that a person or company receives for work they have done – AKA "personal efforts". If you collect regular dividends from a stock, or receive a monetary gift, that money would be considered unearned income because you didn't do anything to earn it.

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