Earned income includes all the taxable income and wages an individual receives from working or from running or owning a business. The most common forms of earned income are wages, salaries, bonuses, commissions, tips, and net earnings from self-employment.
Types of Earned Income
- Wages and Salaries: Payments received from employment, including hourly wages and annual salaries.
- Bonuses and Commissions: Additional income earned for meeting certain performance targets or sales goals.
- Tips: Extra payments given by customers for services provided.
- Net Earnings from Self-Employment: Profits derived from operating a business or engaging in a trade as a sole proprietor or freelancer.
Tax Treatment of Earned Income
Earned income is subject to federal and state income taxes. It is also the basis for calculating Social Security and Medicare taxes, commonly referred to as FICA taxes in the United States.
Earned Income Tax Credit (EITC)
The Earned Income Tax Credit is a benefit for working people with low to moderate income. To qualify for the EITC, you must meet certain requirements and file a tax return, even if you do not owe any tax or are not required to file.
Calculation and Eligibility
- Eligibility: Based on income, filing status, and number of qualifying children.
- Calculation: The amount of the credit varies and is based on income and family size.
Special Considerations
Earned Income vs. Unearned Income
Unearned income, such as interest from savings accounts, dividends, or capital gains, is treated differently for tax purposes. It does not qualify for the EITC and may be subject to different tax rates.
Filing Requirements
Individuals must accurately report all forms of earned income on their tax returns. Failure to do so can result in penalties, interest, and additional tax assessments.
Examples
- Wages: John earns an hourly wage working at a retail store. His paycheck includes FICA deductions.
- Self-Employment: Sarah runs her own photography business. After expenses, her net earnings are subject to self-employment tax.
Historical Context
Earned income and its tax implications have evolved significantly over time. The Earned Income Tax Credit was enacted in 1975 to provide tax relief for low-income working individuals and families, promoting work and reducing poverty.
Applicability
Understanding the nature of earned income and its relevant tax implications is crucial for tax planning and compliance. This knowledge helps individuals maximize their financial benefits and adhere to legal requirements.
Comparisons
Earned vs. Unearned Income
- Earned Income: Directly derived from labor or business activities.
- Unearned Income: Derived from investments or other sources not directly related to active work.
Related Terms
- Gross Income: Total income before any deductions or taxes.
- Adjusted Gross Income (AGI): Gross income minus specific adjustments.
- Taxable Income: AGI minus personal exemptions and standard/itemized deductions.
Frequently Asked Questions (FAQs)
What types of income qualify for the EITC?
Income from wages, salaries, tips, and self-employment qualifies for the EITC.
How is the EITC calculated?
The EITC is calculated based on your earned income, adjusted gross income, and the number of qualifying children.
Can self-employed individuals claim the EITC?
Yes, self-employed individuals can claim the EITC if they meet the eligibility criteria.
References
- Internal Revenue Service (IRS). “Earned Income Tax Credit (EITC).” IRS.
- U.S. Department of the Treasury. “Overview of the Earned Income Tax Credit (EITC).” Treasury.
Summary
Earned income includes wages, salaries, bonuses, and self-employment earnings. It is subject to different tax treatments than unearned income. The Earned Income Tax Credit provides financial relief to low to moderate-income workers. Understanding these elements is key to effective tax planning and compliance.
