Earned income is a term used by the US tax authority – Internal Revenue Service (IRS). The IRS defines earned income as “all the taxable income and wages you get from working or from certain disability payments.”
This is income you earn or receive as a result of active efforts put in[i], as compared to a passive income like earning interest or dividend. Earning comes from employment or taking up a gainful job, where either you work for someone or work for yourself.
Source of earned income
You get an earned income when you work as an employee for someone, who pays you as compensation for the work. Alternately, you may run your own business or venture, in which case the net profits you earn is your earned income.
The following are the inclusions, i.e: the types of income, which are considered by the IRS as earned income[ii]:
- Wages, salaries,tips paid by an employer
- Net earnings from being self-employed if you are running a business or a farm or are a minister or member of a religious order or are a statutory employee having taxable income.
- Disability benefits received on a long-term basis before you attain the age of retirement.
- Benefits related to union strikes.
- If you have nontaxable combat pay, you can consider including it in your earned income, to get earned income tax credit benefits.
The following are not considered by the IRS as earned income:
- Pay received for working in a jail
- Interest and dividends
- Income related to retirement
- Social security benefits
- Unemployment benefits
- Child support
The reason why earned income matters is because of the implications[iii] it has while computing your tax liability. You should have a clear idea of which income is earned and which is not earned. This is needed while filing tax returns and calculating the amount of tax you need to pay.
Some other points you need to keep in mind are:
- If you are getting federal retirement benefits, there is a limit prescribed by the IRS. If the limit is exceeded, you may need to pay back.
- Most employers deduct Medicare and social security taxes, as well as other applicable state and Federal taxes. If you are self-employed, you need to do the computation yourself and pay the applicable taxes.
- If you have hired employees for your business, then you need to work out their earned income and deduct applicable taxes and deposit them.
Earned Income tax credit
EITC or Earned Income Tax Credit[iv] is a tax credit offered by the government to lower-income individuals, as well as families. It is offered for those who have some earned income. This is a credit given on the earned income for the year. The amount of the credit depends on your income and also on the state you live in, as individual states may also offer EITC. This is a reason why you need to be very clear about the earned income inclusions and exclusions as it can have a bearing on the total EITC you can get.
Earned income is the money you earn as compensation for the work you have done. You need to know what qualifies as earned income, as it can have a bearing on your income tax.