Understanding Earned Income and the Earned Income Tax Credit

What Is Earned Income?

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

Income such as investment profits and Social Security payments is considered unearned income, also known as passive income.

Low- and moderate-income earners are eligible for the earned income tax credit (EIC or EITC). This is a tax benefit that reduces the amount of taxes owed and can even result in a refund of taxes paid during the year for those who qualify based on income and number of dependent children.

Understanding Earned Income

For tax purposes, earned income is any money you receive for work you have done for an employer or as an independent contractor.

Examples of income that isn’t considered earned include government benefits such as payments from the Temporary Assistance for Needy Families program, unemployment payments, workers’ compensation payments, and Social Security.

Other types of unearned income are disbursements from non-deferred pensions and retirement plans, alimony, capital gains, interest income, stock dividends, bond interest, passive income generated from rental property, and salaries paid to inmates who work in a penal institution.

Both earned and unearned income are taxable, although the rates differ.

The federal government taxes earned income at seven rates (or brackets), ranging from 0% to 37%. The income levels are adjusted yearly to account for inflation, with different income ranges for single filers, married couples filing jointly, and heads of households.

Tax Considerations

Determining whether your income is earned or unearned, and reporting it on the appropriate lines of a Form 1040 or Form 1040-SR—is relatively straightforward. For some taxpayers, other factors of earned income are worth considering.

If you are receiving Social Security benefits, for example, you have to pay income tax on a portion of those benefits if your overall income is above a certain threshold. In that case, 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 past the minimum age for collecting Social Security benefits.

If you are self-employed, you need to consider how much earned (and unearned) 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 during the year, you’ll have to make it up when you file your annual tax return, and you may have to pay a penalty.

Types of Earned Income

Many taxpayers have more than one source of earned income to report. Below are examples earned income.

• Salaries/Wages: Salaries or wages are the most common type of earned income. These are earnings paid by an employer in exchange for work. In most cases, payment for labor, whether hourly or salary, counts as earned income.
• Self-employment income: Whether you work for yourself or as a contractor, this is earned income. Self-employed individuals include freelancers, consultants, and small business owners.
• Tips and commissions: Tips, commissions, and other non-guaranteed income are payments that individuals receive in addition to a regular salary or wages. Tips are common in the service industry, while commissions are often paid to salespeople.
• Bonuses: Bonuses are another type of non-guaranteed payment that employees may receive for meeting certain performance goals or achieving other milestones. Because this is additional compensation, it is considered earned income.
• Honorarium: Honorariums are payments for services such as speaking at an event or participating in a convention. Because this payment is being exchanged for a service, it is earned income.
• 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 your income is below certain thresholds, you are eligible for the federal earned income tax credit (EIC or EITC), a refundable tax credit that can reduce your tax bill or even result in a refund of taxes paid during the year. The income levels and the credit amounts vary depending on your family size and filing status.

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, offset the effect of Social Security taxes, and encourage work. It continues to be viewed as an anti-poverty tax benefit.

Qualifications for the EITC

To qualify for the EITC, you must have worked during the year and earned an income below certain thresholds. The amount of the tax credit depends on the filer's marital status and number of dependents. The income thresholds for the credit are also adjusted each year to keep up with inflation.

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.

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 be included in any tax filing software you use.

Example of Earned Income

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

In this example, the taxpayer must calculate their earned income to determine 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.

Unearned income is recorded separately on line 21 of Form 1040.

The Bottom Line

Earned income is any compensation that you receive from a job or self-employment. It can include wages, tips, salaries, commissions, or bonuses. It is different from unearned income, which comes from sources like investment profits 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 lowers your tax bill or even results in a refund of taxes paid.