Understanding Earned Income and the Earned Income Tax Credit

What Is Earned Income?

Earned income is money received as pay for work performed, such as wages, salaries, bonuses, commissions, tips, and net earnings from self-employment. It can also include long-term disability, union strike benefits, and, in some cases, payments from certain deferred retirement compensation arrangements.

Earned income can be contrasted with unearned income, also known as passive income, which is money not acquired through working.

Key Takeaways

  • Earned income is any income received from a job or self-employment.
  • Earned income may include wages, salary, tips, bonuses, and commissions.
  • Income derived from investments and government benefit programs would not be considered earned income.
  • Earned income is taxed differently from unearned income.
  • Employed taxpayers with lower incomes may be eligible for an earned income tax credit (EITC).

Understanding Earned Income

For tax purposes, earned income is any income you receive for work you have done for an employer or a business of your own.

Examples of income that isn’t considered earned include government benefits, such as payments from the Temporary Assistance for Needy Families program (often referred to as welfare), unemployment, workers’ compensation, and Social Security. Also excluded are disbursements from non-deferred pensions and retirement plans, alimony, capital gains, interest income from a bank account, stock dividends, bond interest, passive income generated from rental property, and salaries paid to inmates who work in a penal institution.

Both earned and other types of income are generally taxable, although sometimes at different percentage rates. For example, in the 2022 and 2023 tax years, the federal government taxes earned income at seven separate rates (or brackets), ranging from 10% to 37%. The thresholds tend to rise yearly to account for inflation and differ for single filers, married couples filing jointly, and heads of households.

Long-term capital gains on assets held for a year or more are taxed at 0%, 15%, and 20%, depending on the amount and your filing status. Short-term capital gains, which have been held for less than a year, are taxed at the same rate as your earned income.

Tax Considerations

Determining whether income is earned or unearned—and reporting it on the appropriate lines of a Form 1040 or other tax return—is relatively straightforward. For some taxpayers, however, other ramifications of earned income are worth considering.

If you are receiving Social Security benefits, for example, you may have to pay income tax on a portion of those benefits if you have earned income (or other income) over a certain threshold. In that case, up to either 50% or 85% of your benefits will be subject to tax, depending on your income and filing status. This can be an important consideration for people who plan to continue working after they are eligible for Social Security benefits or are deciding whether to delay filing for benefits.

If you are self-employed, you also need to consider how much earned (and other) income you expect to have for the year and pay estimated taxes each quarter based on that amount. If you fail to pay enough tax throughout the year, you’ll have to make it up when you file your tax return, and you also may be subject to Internal Revenue Service (IRS) penalties.

If you receive Social Security benefits, having earned income can affect whether those benefits are taxable.

Types of Earned Income

Taxpayers may collect an array of earned income, and a single taxpayer may collect more than one type of earned income at any given time. Below are examples of types of earned income.

  • Salaries/Wages: Salaries or wages are the most common type of earned income. Salaries or wages refer to the amount of money that an individual earns from their employer in exchange for their work. In most cases, payment for labor, whether hourly or salary, counts as earned income.
  • Self-Employment Income: On a similar note, it may not matter who pays you. Whether you work for yourself or for someone else's company, both types of income are considered earned. For self-employed individuals, this includes freelancers, consultants, and small business owners.
  • Tips and Commissions: Tips, commissions, or other non-guarantee types of pay are payments that individuals receive in addition to their regular salary or wages. Tips are common in the service industry, while commissions are often paid to salespeople or other individuals who earn a percentage of sales they generate. Both types may or may not be paid out, yet both are commonly treated as earned.
  • Bonuses: Bonuses are another type of non-guaranteed payment that individuals may receive from their employer for meeting certain performance goals or achieving other milestones. Because this is additional compensation earned during the course of work for performance, it is considered earned.
  • Honorarium: Honorariums are payments for services such as speaking at an event, writing an article, or participating in a convention. Because this payment is being exchanged for a service, it is earned.
  • Long-term disability benefits: Long-term disability retirement benefits claimed before reaching the minimum retirement age may qualify as earned income.

Earned Income Tax Credit (EITC)

If you have a relatively low earned income and meet other qualifications, you may be eligible for the federal earned income tax credit (EIC or EITC), a refundable tax credit that can reduce your tax bill or result in a refund. To qualify for the credit, you must file a tax return even if you don’t owe any tax or otherwise wouldn’t be required to file one.

The EITC was conceived as a type of “work bonus plan” to supplement the wages of low-income workers, help offset the effect of Social Security taxes, and encourage work as a way to move people off welfare. It continues to be viewed as an anti-poverty tax benefit aimed to reward people for employment.

Qualification for the Earned Income Tax Credit

To qualify for the EITC, you must have worked during the year and earned an income below $59,187. You may have investment income, but it must be below $10,300. You must also:

  • Have a valid Social Security number by the due date of your tax return (includes extensions)
  • Be a U.S. citizen or a resident alien all year
  • Not file Form 2555 for Foreign Earned Income
  • Meet certain qualifying rules if you are separated from your spouse and not filing a joint tax return

The amount of EITC benefit you can receive depends on your income and the number of dependents you claim:

Number of Children 2022 (filed in 2023) 2023 (filed in 2024)
 0  $560 $600 
 1  $3,733  $3,995
 $6,164  $6,604
3 or more $6,935 $7,430

If you are unsure whether you qualify or have questions about your specific situation, seek advice from the IRS or an independent tax expert. Most of this information will also be included in any tax filing software you use.

Example of Earned Income

Imagine a taxpayer who earned a $50,000 salary from their day job, $10,000 bonus for their performance, $5,000 wage from their side gig, and $500 tip for that side gig. In addition, that taxpayer earned $1,000 in ordinary dividends and recognized $25,000 of capital gain distributions.

In this example, the taxpayer must calculate their earned income to appropriately their tax liability. Based on the numbers above, the only forms of earned income include:

  • Salary ($50,000)
  • Bonus ($10,000)
  • Wages ($5,000)
  • Tips ($500)

Therefore, the taxpayer's earned income is $65,500. The remaining $26,000 ($1,000 of ordinary dividends and $25,000 of capital gain distributions) are not considered earned income.

What Are Some Examples of Unearned Income?

Unearned income includes interest from savings, certificates of deposit (CDs), or other bank accounts, bond interest, alimony, capital gains, and dividends from stock. Income from retirement accounts, Social Security benefits, inheritances, gifts, welfare payments, rental income, and annuities are all also classified as unearned income.

How Do I Know If I Have Earned Income?

First, you need to know if you had any type of income at all. Consider avenues in which you received compensation in return for something, whether it was time spent working a job or profit for selling something.

Then, compared your activity against IRS-guidance manuals to determine if that activity is earned or unearned income. Very broadly speaking, if you earned money for a job, it was likely earned income.

What Is the Difference Between Earned and Unearned Income?

Earned income comes from working, while unearned income does not. The IRS may treat each type of income differently for tax purposes. Tax rates vary among sources of unearned income; most unearned income sources are not subject to payroll taxes, and none of them are subject to employment taxes such as Social Security and Medicare. Unearned income cannot be used to contribute to a qualified retirement account such as an IRA.

The Bottom Line

Earned income is any income that you receive from a job or self-employment. It can include wages, tips, salary, commissions, or bonuses. It is different from unearned income, which comes from things like investments or government benefits. The two types of income are taxed differently by the IRS.

If you have earned income that is below a certain threshold, you may qualify for the earned income tax credit. This is a refundable tax credit that can lower your tax bill or result in a tax refund.

Article Sources
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