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 and union strike benefits and, in some cases, payments from certain deferred retirement compensation arrangements.
- Earned income is any income that is 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 often 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, either 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 income and other types of income are generally taxable, although sometimes at different percentage rates. In the 2021 and 2022 tax years, the federal government taxes earned income at seven separate rates (or brackets), ranging from 10% to 37%. The thresholds tend to rise each year 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 (which are classified as portfolio income) are taxed at 0%, 15%, and 20%, depending on the amount and the taxpayer’s filing status, whereas short-term capital gains, which cover assets held for less than a year, are taxed at the
same rate as a taxpayer’s earned income.
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, either up to 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 may also be subject to Internal Revenue Service penalties.
Having earned income can affect whether a retiree’s Social Security benefits are taxable.
The 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), which 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 wouldn’t otherwise 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 so as to move people off welfare. It continues to be viewed as an anti-poverty tax benefit aimed to reward people for employment.
Note that as part of the American Rescue Plan Act of 2021, the EITC cap is temporarily raised from $543 for childless households to $1,502 for 2021. The bill also expands eligibility for childless households.
As usual in these matters, if you are unsure about whether you qualify or have questions about your specific situation, seek advice from the IRS or an independent tax expert.
What Are Some Common Examples of Earned Income?
According to the IRS, earned income only includes money received as pay for work performed. Earned income includes only wages/salary, commissions, bonuses, and business income (minus expenses if the person is self-employed).
What Are Some Examples of Unearned Income?
Examples of unearned income include interest from savings, 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, lottery or gambling winnings, and annuities are all also classified as unearned income.
What Is the Difference Between Earned and Unearned Income?
Aside from the differences in how the income is generated (i.e. earned through working or not), the IRS may treat each differently for tax purposes. Tax rates vary among sources of unearned income, with most unearned income sources not subject to payroll taxes, and none of them subject to employment taxes such as Social Security and Medicare. Additionally, unearned income cannot be used for making contributions to a qualified retirement account such as an IRA.