When you own or work for a business, you receive earned income, but that term doesn’t include all income. Understanding the difference between income that is earned and unearned is essential for determining tax liability and tax credit eligibility. So what qualifies as earned income?
What Is Earned Income?
A person’s earned income is the total taxable compensation an employee makes or the net earnings of a self-employed individual. Both employees and self-employed workers pay taxes based on that amount. Wages or salaries contribute to this income, but they aren’t the only type of compensation that is included. A list of income which the IRS considers to be earned includes the following:
- Wages, salaries, tips, commissions, and bonuses
- Self-employed earnings after deducting business expenses
- Statutory employee net earnings
- Union strike benefits
- Disability retirement benefits received before the minimum retirement age
- Nontaxable combat pay, if elected.
What Income is Not Earned?
However, you may make some income, which is not considered “earned” by the IRS. A few examples of unearned revenue include:
- Interest earned
- Social Security benefits
- Workers’ compensation benefits
- Welfare benefits
- Child support
- Payment for work done while incarcerated
- Disability benefits received after reaching retirement age
- Disbursements from non-deferred retirement plans
- Pensions or annuities
When you receive any of these unearned incomes, you do not owe payroll taxes on that amount. However, you do owe taxes on unearned income.
How Earned Income Affects Taxes
Knowing your earned income amount is important for tax purposes. For an employee, employment taxes include income, Social Security, and Medicare taxes. For a self-employed individual, any income deemed “earned” is subject to income tax and self-employment tax. To determine your liability or your employee’s tax liability, you need to know the amount of earned income subject to taxation.
How IRA Contributions Are Affected
If you or an employee of yours want to contribute to an Individual Retirement Account (IRA), you must receive income labeled as earned. Additionally, this amount may also be a baseline for how much you can add to your IRA. If you make below the contribution limit, you cannot contribute more than your earned income amount to your IRA.
Your Income Tax Credit
Earned income is also significant because it affects your eligibility for the earned income tax credit (EITC or EIC). The EITC is an IRS program that helps to alleviate tax liability for low- and moderate-income individuals. The EITC is also a refundable tax credit, which means that people with a higher tax credit than tax liability receive a refund.
The credit amount you can receive depends on how much you receive per year, and you cannot receive the tax credit if your earned income is above the IRS threshold.
As an employer, you must let employees know about the EITC if you do not withhold federal income tax from their income. You can let your employee know by providing Notice 797, but you do not have to give that Notice if the employee claimed exemption from income tax withholding.
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