When it comes to taxes and financial planning, you need to know the IRS has different rules for different types of income. Earned income, the money you make from working, affects everything from how much taxes you pay to whether you qualify for certain deductions or credits. Whether you’re earning a paycheck from an employer, running your own business or freelancing on the side, knowing how to identify and calculate your earned income can help you stay compliant with IRS rules and potentially lower your tax bill.
Managing taxes can be challenging, but an experienced financial advisor can help simplify the process.
What Is Earned Income?
Earned income refers to compensation from active work, such as wages, salaries, tips or self-employment earnings. This differs from unearned income, which comes from sources like investments, interest or rental properties.
Generally, the IRS considers earned income what you receive for performing work or services. For the employed, earned income typically includes your wages or salary. For the self-employed, income typically encompasses business profits.
Here are some common examples of earned income:
- Salaries and wages. This includes hourly pay, annual salaries, overtime and bonuses.
- Self-employment earnings. Income from businesses, freelancing, or contract work like consulting fees. However, you may not have this income come through you directly, depending on how you register your business.
Here are some examples of what is not considered earned income:
- Interest and dividends. This passive income comes from investments, such as stock or bonds.
- Capital gains. The IRS considers profits from selling investments or property as unearned income.
- Retirement distributions. Pension payments, Social Security benefits, and withdrawals from individual retirement accounts(IRAs) or 401(k)s.
- Unemployment compensation. While it replaces earned income, IRS rules do not consider it earned income.
- Alimony and child support. Though these payments provide financial support, they are not classified as earned income.
How Earned Income Is Calculated
Calculating earned income starts with identifying any compensation you receive in exchange for active work like wages, salaries, tips and commissions. For self-employed or business owners, you calculate earned income by subtracting business expenses from your gross revenue to get your net profit.
For Employees:
If you work for an employer, earned income typically includes:
- Hourly wages or salary
- Overtime pay
- Bonuses and commissions
- Tips and gratuities
For Self-Employed Individuals:
Freelancers, contractors, or business owners calculate earned income using the following:
- Gross income from your business
- Minus allowable business expenses
For example, say you operate a consulting business that brings in $120,000 in gross revenue. After deducting $35,000 in expenses — such as office supplies, marketing costs and travel — you’re left with $85,000 in net earnings, which is your earned income for tax purposes.
Earned Income vs. Unearned Income
The distinction between earned and unearned income can help you better manage your finances and plan your taxes. Here are four key differences to consider:
- Income source. Simply put, earned income comes from active work. For example, self-employment income if you’re running your own consulting business. Unearned income, on the other hand, comes from passive sources, such as dividends and interest from investments, gains from the sale of investment assets, retirement distributions, unemployment benefits and various government support payments.
- Tax treatment. The IRS taxes earned income at ordinary income rates and is subject to payroll taxes for Social Security (up to the annual cap) and Medicare. Unearned income receives different tax treatment. The IRS taxes capital gains and qualified dividends at preferred rates, but taxes ordinary dividends and interest income at ordinary rates. Some unearned income sources may require an additional 3.8% net investment income tax (NIIT).
- Limits and exclusions. Not all income can be classified as earned or unearned. For example, incentive stock options (ISOs) do not create income impacts until exercised or sold.
- Tax benefit eligibility. Some tax credits and deductions, like the earned income tax credit (EITC), are available only for taxpayers with earned income.
Frequently Asked Questions
Can Passive Income Be Considered Earned Income?
Passive income, by definition, is typically not classified as earned income. However, the IRS may occasionally reclassify some types of passive income under specific circumstances.
How Is the Earned Income Tax Credit Determined?
The EITC is calculated based on your earned income, adjusted gross income and the number of qualifying children you have. Using an EITC calculator can provide a more personalized estimate.
Bottom Line
Whether you’re earning a steady paycheck, running your own business or taking on freelance work, knowing how your income is classified is key to staying compliant with tax rules and unlocking potential tax benefits. If you’re unsure how to categorize your earnings or want to optimize your financial strategy, working with a financial advisor can help you stay on track and make the most of your income.
Tax Planning Tips
- If you’re looking for ways to lower your tax liability, a financial advisor can help optimize your finances. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much your next tax refund or balance could be, SmartAsset’s tax return calculator can help you get an estimate.
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