What is Earned Income?
Earned income refers to money and compensation that you receive in return for work and services you provide. The key qualifier is that the income involves some active effort on your part in order to receive the payment.
Earned income is taxed differently than unearned income that comes from investments, rents, pensions, inheritance, social security, alimony, child support, and other sources where you are not actively working to earn the income directly.
Some examples of common earned income sources include:
- Wages, salaries, commissions, bonuses, and tips from employment
- Strike benefits from unions
- Long-term disability benefits prior to minimum retirement age
- Net income from self-employment businesses and independent contractor work after deducting allowable business expenses
- Any other income you receive directly in exchange for personal services
Major Sources of Earned Income
Wages, Salaries, and Tips Income you earn as an employee in exchange for your labor is considered earned income. This includes:
- Regular wages and salaries
- Overtime pay
- Bonuses
- Commissions
- Paid vacation or sick leave
- Tips reported to your employer
Union Strike Benefits If you participate in a strike organized by your labor union and receive income from the union pay fund, this is considered earned income.
Long-Term Disability Benefits If you receive long-term disability insurance benefits before you reach minimum retirement age, then the benefits are included in earned income. Once you reach full retirement age as defined by Social Security, disability benefits become classified as unearned income.
Net Earnings from Self-Employment If you are self-employed, income left over after deducting all allowable business expenses is considered earned income because it directly results from your labor and services provided. Common self-employment activities like consulting, freelancing, sole proprietorships, partnerships, etc., fall into this category.
You calculate the net earnings from self-employment on Schedule SE when you file your tax return. Deductions reduce your overall earned income amount.
How Earned Income is Taxed
Earned income is subject to both federal and state income tax. All wages, salaries, and net self-employment income must be reported on your tax return.
In addition, earned income is subject to payroll taxes which fund Social Security and Medicare:
- Social Security: A 6.2% payroll tax on the first $147,000 of earnings in 2023.
- Medicare: A 1.45% payroll tax on all earnings. An extra 0.9% tax applies for earnings above $200,000.
Employers automatically withhold federal and state income taxes, as well as Social Security and Medicare taxes, from wage and salary payments to employees.
For self-employed individuals, payroll taxes for Social Security and Medicare must be paid quarterly on IRS Form 1040-ES. You also calculate any additional self-employment taxes owed when you file your annual tax return.
Reporting Earned Income
You must report all sources of earned income on your annual tax return:
W-2s Employers issue Form W-2 to employees, detailing:
- Total wages and compensation
- Federal, state, Social Security, and Medicare taxes withheld
Each tax year, you must attach W-2s to your return to report your earned wages and salaries.
1099s You receive a Form 1099-MISC, 1099-NEC, or 1099-K reporting any non-employee compensation, freelance work, or self-employment income you were paid. Attaching these forms reports your earned income from these sources.
Schedule SE Use Schedule SE to calculate the full Social Security and Medicare taxes owed on your net earnings from self-employment. This includes income reported on 1099s or from your own business.
How Earned Income Impacts Your Taxes
Eligibility for Tax Credits The amount of your earned income helps determine your eligibility and calculation for certain tax credits like:
- Earned Income Tax Credit
- Child Tax Credit
- Child and Dependent Care Credit
Having earned income can qualify you for credits that you may not receive based on unearned income alone.
Self-Employment Tax Calculations Your net earnings from self-employment determine how much you owe in Social Security and Medicare payroll taxes. Strategic business deductions can reduce your taxable self-employment income.
IRS Notice Triggers Reporting substantial earned income can prompt IRS notices to verify your tax return accuracy if your income seems inconsistent with past amounts. Proper documentation is key to validating earned income amounts.
Maximize Earned Income Benefits
- Take all allowable and eligible deductions against your earned income to reduce taxable amounts.
- Consider the tax implications when deciding when to receive income or incur expenses. Proper timing can help defer tax liability.
- Maintain detailed records and track all your different sources of earned income separately by type and origin.
Common Questions
How are bonuses taxed? Bonuses are considered supplemental wages and taxed as regular earned income. Most employers withhold a flat 22% for federal income tax only, so additional taxes may be owed.
Can I deduct home office expenses? Yes, if part of your home is used regularly and exclusively for conducting your work, you can deduct a prorated portion of utilities, insurance, etc. based on square footage.
What if I’m both self-employed and an employee? You will receive both W-2s for your wages as well as 1099s for your self-employment activity. Report all earned income and calculate self-employment tax on your net business earnings.
Do stock dividends count as earned income? No, investment income from dividends, interest, capital gains, etc., is considered unearned income, separate from the compensation for your labor.
Are illegal earnings considered earned income? Yes, the IRS considers income from illegal activities like selling prohibited substances as taxable earned income that must also be reported, even though the activities are unlawful.
